1031 Tax Exchange Frequently Asked Questions

1031 Tax Exchange – Frequently Asked Questions
After years of​ conducting tens of​ thousands of​ successful 1031 exchanges,​ we found that there are a​ number of​ frequently asked questions related to​ this type of​ transaction…
Equity and Gain
Is my tax based on​ my equity or​ my taxable gain?
Tax is​ calculated upon the​ taxable gain .​
Gain and equity are two separate and distinct items .​
To determine your gain,​ identify your original purchase price,​ deduct any depreciation which has been previously reported,​ then add the​ value of​ any improvements which have been made to​ the​ property .​
The resulting figure will reflect your cost or​ tax basis .​
Your gain is​ then calculated by subtracting the​ cost basis from the​ net sales price.
Deferring All Gain
Is there a​ simple rule for structuring an​ exchange where all the​ taxable gain will be deferred?
Yes,​ the​ gain will be totally deferred if​ you:
1) Purchase a​ replacement property which is​ equal to​ or​ greater in​ value than the​ net selling price of​ your relinquished (exchange) property,​ and
2) Move all equity from one property to​ the​ other.
Definition of​ Like-Kind
What are the​ rules regarding the​ exchange of​ like-kind properties? May I​ exchange a​ vacant parcel of​ land for an​ improved property or​ a​ rental house for a​ multiple-unit building?
Yes,​ like-kind refers more to​ the​ type of​ investment than to​ the​ type of​ property .​
Think in​ terms of​ investment real estate for investment real estate,​ business assets for business assets,​ etc.
Simultaneous Exchange Pitfalls
Is it​ possible to​ complete a​ simultaneous exchange without an​ intermediary or​ an​ exchange agreement?
While it​ may be possible,​ it​ may not be wise .​
With the​ Safe Harbor addition of​ qualified intermediaries in​ the​ Treasury Regulations and the​ recent adoption of​ good funds laws in​ several states,​ it​ is​ very difficult to​ close a​ simultaneous exchange without the​ benefit of​ either an​ intermediary or​ exchange agreement .​
Since two closing entities cannot hold the​ same exchange funds on​ the​ same day,​ serious constructive receipt and other legal issues arise for the​ Exchangor attempting such a​ simultaneous transaction .​
The addition of​ the​ intermediary Safe Harbor was an​ effort to​ abate the​ practice of​ attempting these marginal transactions .​
It is​ the​ view of​ most tax professionals that an​ exchange completed without an​ intermediary or​ an​ exchange agreement will not qualify for deferred gain treatment .​
And if​ already completed,​ the​ transaction would not pass an​ IRS examination due to​ constructive receipt and structural exchange discrepancies .​
The investment in​ a​ qualified intermediary is​ insignificant in​ comparison to​ the​ tax risk associated with attempting an​ exchange,​ which could be easily disqualified.
Property Conversion
How long must I​ wait before I​ can convert an​ investment property into my personal residence?
A few years ago the​ Internal Revenue Service proposed a​ one-year holding period before investment property could be converted,​ sold or​ transferred .​
Congress never adopted this proposal,​ so therefore no definitive holding period exists currently .​
However,​ this should not be interpreted as​ an​ unwritten approval to​ convert investment property at​ any time .​
Because the​ one-year period clearly reflects the​ intent of​ the​ IRS,​ most tax practitioners advise their clients to​ hold property at​ least one year before converting it​ into a​ personal residence.
Remember,​ intent is​ very important .​
It should be your intention at​ the​ time of​ acquisition to​ hold the​ property for its productive use in​ a​ trade or​ business or​ for its investment potential.
Involuntary Conversion
What if​ my property was involuntarily converted by a​ disaster or​ I​ was required to​ sell due to​ a​ governmental or​ eminent domain action?
Involuntary conversion is​ addressed within Section 1033 of​ the​ Internal Revenue Code .​
If your property is​ converted involuntarily,​ the​ time frame for reinvestment is​ extended to​ 24 months from the​ end of​ the​ tax year in​ which the​ property was converted .​
You may also apply for a​ 12-month reinvestment extension.
Facilitators and Intermediaries
Is there a​ difference between facilitators?
Most definitely .​
As in​ any professional discipline,​ the​ capability of​ facilitators will vary based upon their exchange knowledge,​ experience and real estate and/or tax familiarity.
Facilitators and Fees
Should fees be a​ factor in​ selecting a​ facilitator?
Yes .​
However,​ they should be considered only after first determining each facilitator's ability to​ complete a​ qualifying transaction .​
This can be accomplished by researching their reputation,​ knowledge and level of​ experience.
Personal Residence Exchanges
Do the​ exchange rules differ between investment properties and personal residences? If I​ sell my personal residence,​ what is​ the​ time frame in​ which I​ must reinvest in​ another home and what must I​ spend on​ the​ new residence to​ defer gain taxes?
The rules for personal residence rollovers were formerly found in​ Section 1034 of​ the​ Internal Revenue Code .​
You may remember that those rules dictated that you​ had to​ reinvest the​ proceeds from the​ sale of​ your personal residence within 24 months before or​ after the​ sale,​ and you​ had to​ acquire a​ property which reflected a​ value equal to​ or​ greater than the​ value of​ the​ residence sold .​
These rules were discontinued with the​ passage of​ the​ 1997 Tax Reform Act .​
Currently,​ if​ a​ personal residence is​ sold,​ provided that residence was occupied by the​ taxpayer for at​ least two of​ the​ last five years,​ up to​ $250,​000 (single) and $500,​000 (married) of​ capital gain is​ exempt from taxation.
Exchanging and Improvements
May I​ exchange my equity in​ an​ investment property and use the​ proceeds to​ complete an​ improvement on​ a​ vacant lot I​ currently own?
Although the​ attempt to​ move equity from one investment property to​ another is​ a​ key element of​ tax deferred exchanging,​ you​ may not exchange into property you​ already own.
Related Parties
May I​ exchange into a​ property that is​ being sold by a​ relative?
Yes .​
However,​ any exchange between related parties requires a​ two-year holding period for both parties.
Partnership or​ Partial Interests
If I​ am an​ owner of​ investment property in​ conjunction with others,​ may I​ exchange only my partial interest in​ the​ property?
Yes .​
Partial interests qualify for exchanging within the​ scope of​ Section 1031 .​
However,​ if​ your interest is​ not in​ the​ property but actually an​ interest in​ the​ partnership which owns the​ property,​ your exchange would not qualify .​
This is​ because partnership interests are excepted from Section 1031 .​
But don't be confused! If the​ entire partnership desired to​ stay together and exchange their property for a​ replacement,​ that would qualify.
Another caveat .​
Those individuals or​ groups owning partnership interests,​ who desire to​ complete an​ exchange and have for tax purposes made an​ election under IRC Section 761(a),​ can qualify for deferred gain treatment under Section 1031 .​
This can be a​ tricky issue! See elsewhere in​ this publication for more information .​
Then,​ only undertake this election with proper tax counsel and only with the​ election by all partners!
Reverse Exchanges
Are reverse exchanges considered legal?
Although reverse exchanges were deliberately omitted from Section 1031,​ they can still be accomplished with the​ aid of​ an​ experienced intermediary .​
Since reverses are considered an​ aggressive form of​ exchanging,​ your intermediary and tax advisor should assist you​ with exchange and tax planning based upon successful reverse exchange case law.
The Taxation Section of​ the​ American Bar Association has submitted suggested guidelines for the​ IRS in​ evaluating reverse exchanges and issuing new regulations .​
Although it​ is​ unknown when the​ IRS will make a​ definitive reverse exchange ruling,​ one is​ expected in​ the​ future.
Why are the​ identification rules so time restrictive? is​ there any flexibility within them?
The current identification rules represent a​ compromise which was proposed by the​ IRS and adopted in​ 1984 .​
Prior to​ that time there were no time-related guidelines .​
The current 45-day provision was created to​ eliminate questions about the​ time period for identification and there is​ absolutely no flexibility written into the​ rule and no extensions are available.
In a​ delayed exchange,​ is​ there any limit to​ property value when identifying by using the​ 200% rule?
Yes .​
Although you​ may identify any three properties of​ any value under the​ three property rule,​ when using the​ 200% rule there is​ a​ restriction .​
It is​ when identifying four or​ more properties,​ the​ total aggregate value of​ the​ properties identified must not exceed more than 200% of​ the​ value of​ the​ relinquished property.
An additional exception exists for those whose identification does not qualify under the​ three property or​ two hundred percent rules .​
The 95% exception allows the​ identification of​ any number of​ properties,​ provided the​ total aggregate value of​ the​ properties acquired totals at​ least 95% of​ the​ properties identified.
Should identifications be made to​ the​ intermediary or​ to​ an​ attorney or​ escrow or​ title company?
Identifications may be made to​ any party listed above .​
However,​ many times the​ escrow holder is​ not equipped to​ receive your identification if​ they have not yet opened an​ escrow .​
Therefore it​ is​ easier and safer to​ identify through the​ intermediary,​ provided the​ identification is​ postmarked or​ received within the​ 45-day identification period.

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