1031 EXCHANGES
The
1031 exchange is part of federal tax law-Internal Revenue Section
1031. Section
1031 allows for exchange of
personal property as well. With the appreciation of property, many
property owners do not want to sell and be required to pay high
taxes. An exchange allows the owner to save on taxes and thus have
more money to invest in a new property. An exchange allows allows
them tit defer tax liability.
Example:
John owns 10 unit apartment he wants to sell and buy 20 unit
apartment, Ten unit would sell for $600,000 with selling cost of
$25,000 and adjusted basis of $275,000. His taxable gain would
be:
Sales price: $600,000
Selling
price: $-25,000
Net Sales price: $575,000
Adjusted
basis: $275,000
Taxable gain: $300,000
If he sells the property, he will have to pay federal and state
taxes on the gain. He would be taxed at 15% capital gains tax rate.
These taxes would be to be paid out of the proceeds from the sale.
If he exchanges rather than sell, he would have entire equity to
invest in the new property and could defer any tax liability.
Who prepares exchange. Most agents think of
A exchanging with B. The most widely used exchange is buy0sell
exchange sometimes called a three-corner exchange or three-legged
exchange, The three people involved are the exchanger,(person
wanting to exchange), the seller ( a person want to sell property)
and a the buyer ( person who wants to buy a property).
The exchange may be structured in two different ways. The buyer
offers to buy the exchange property, but the buyer does not have any
property to exchange. So the exchanger needs to find another
property the property he or she wants to acquire. When the exchanger
finds the property, the buyer buys this property from the seller.
Now the buyer has a property to exchange with the exchanger. To
satisfy the IRS, the buyer will buy the seller's property and
exchange with the exchanger, and this is all done in escrow in a
matter of minutes.
Example: E wants to complete 1031 exchange and S and B agree. E
will transfer his property to B, and S will transfer his property to
E to complete the exchange.
S - to- E - to - B
S-seller
E-Exchanger
B-buyer
Example 2: If the exchange is invalid, than, the escrow
instruction were to read: "S will transfer his property to B, B will
transfer S's property to E, and E will transfer his property to
B.
The Buy Up Rule.
With the buy up rule, to qualify for totally tax-deffered
exchange, the exchanger needs to trade up in value. Trade up means
the new property must be equal to or greater in value than the old
property. If the exchanger withdraws any cash, the cash withdrawn
will be taxable. Withdrawing cash will not disallow the exchange-an
exchange may be partial.
Example: E wants to complete 1031. The market value of his
property is $350,000, therefore the property he is trading must be
valued at $350,00 or more. If E nets $150,000 after the sale, that
is E paid off his loan of $200,000 and takes out $50,000, he will
pay taxes on $50,000. Only the $100,000 he put into the new property
will be deffered.
The Investment Property Rule.
The investment property rule comes from IRS code
1031(a)(1):
In general- no gain or no loss shall be recognized on
the exchange of property held for productive use in trade or
business or for investment if such property is exchanged solely for
property of like kind which is to be held either for productive use
in a trade or business or for investment..
Note: A personal residence is not held for productive use in a
trade or business or for investment. Therefore, a person cannot have
a tax deferred exchange of his or her personal residence for
business or investment property.
Like Kind Rule.
Exchanges of property must observe the like-kind rule. In
exchanging, property is categorized as either personal or real
property.
For personal property, like kind property must be exactly the
same in character or have the same nature, and this sometimes is
very difficult to determine.
No gain or loss is recognized if (1) a taxpayer exchanges
property held for productive use in his trade or business, together
with cash, for other property of like kind for the same use, such as
an automobile to be used for a like purpose. [Reg.1.1031(1)-1(c)
0(1)]
For real property, like-kind property is simply any piece of real
property exchanged for any other piece of real property.
As uses in section 1032(a), the words "like kind" have reference
to the nature or character of the property and not to its grade or
quality. One kind or class of property may not, under that section,
be exchanged for property of a different kind or class. The fact
that any real estate involved is improved or unimproved is not
material, for the fact related only to the grade or quality of the
property and not its kind or class. Unproductive real estate held by
one other than a dealer for future use or future realization of the
increment in value is held for investment and not primarily for
sale. [Reg.1.1031(1)-1(b)]
…[A] taxpayer, who is not a dealer in real estate, exchanges city
real estate for a ranch or far,, or exchanges a leasehold fee with
30 years or more to run for real estate, or exchanges improved real
estate for unimproved real estate, or (3) a taxpayer exchanges
investment property and cash for investment property of like kind.
[Reg.1.1031(a)-1(c) -(2),(3)]
Therefore, the general rule for real property is that any piece
of real property may be exchanged for any other piece of real
property, except for inventory and personal residences.
No choice Rule.
If an exchange qualifies as an exchange, it must be treated as an
exchange. If the real estate transaction was structured as an
exchange. If the real estate transaction was structured as an
exchange, the gain must be deferred (postponed). The no-choice rule
can be stated simply: An exchanger who qualifies for 1031 tax
deferred exchange has no choice; the exchanger cannot recognize the
gain or loss.
No Loss Rule.
In conjunction with no choice rule called the no loss rule. If a
real estate transaction qualifies as an exchange, a loss cannot be
recognized. Losses must be deferred along with gains. The no-loss
rule comes from IRC Section 1031(a)(1):
…no gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or for
investment if such property is exchanged solely for property of like
kind which is to be held either for productive use in a trade or
business or for investment, No loss can be recognized if the
transaction is a tax deferred exchange.
Delayed Exchange. IRC
Section 1031(a)(3) allows a delayed exchange with the following
characteristics:
Requirement that property be identified within 45 days and that
exchange be completed no more than 180 days after transfer of
exchanged property.
45 days to designate potential property - 180 days to close
escrow on new property
Reverse Exchange.
In a reverse exchange the replacement property is acquired prior
to the property owner giving up his or her property. An exchange
accommodation titleholder takes title to the property the exchanger
wishes to acquire and hold the title until the sale of the exchange
property can be arranged. This type of exchange removes the problem
of acquiring property within a prescribed time period of the delayed
exchange. The sale must be within 180 days.
Boot.
Property that is not like kind and does not qualify for an
exchange is called boot. Boot is taxable to the person receiving it.
Property needs to qualify as like kind only to the person seeking
the tax deferred exchange.
Boot maybe classified as cash boot or mortgage boot. Cash
boot is a result of the balancing equities, which must be done in
every exchange. It is defined as all other unlike properties: cash,
paper (trust deeds or notes), and personal properties (cars, boats,
planes, paintings, etc.).
Mortgage Boot is the difference between the loans in the conveyed
property and the loans on the acquired property. This is also called
debt relief.
If the client assumes a mortgage larger than the one that he or
she conveys, than he or she has paid mortgage boot. However, if he
or she assumes a mortgage that is less than the one that he or she
conveys, than he or she has received mortgage boot (debt
relief)
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