1031 Exchange

How did the 1031 come about ?            

A 1031 tax exchange (commonly referred to as a “Starker Exchange”) was so aptly named after a 1979 case (involving T.J. Starker) which “broke the mold” for 1031 tax-deferred treatment in like-kind exchanges…

Prior to the Starker case, the IRS thought all exchanges had to be done simultaneously (i.e. direct swaps between parties).

T.J. Starker thought differently. He was a wealthy land-owner who entered into a “land-exchange agreement” to give up his relinquished property (which was a large holding of timber-land in Columbia, Oregon) to a company named, “Crown Zellerbach Corporation”. In return, “Crown Zellerbach” was to give T.J. replacement-properties – located in Washington and Oregon – during the next 5 years (T.J. was allowed to identify his replacement-properties during this 5 year period).

What was different about this transaction is that T.J. Starker was extending the 1031 process over 5 years (rather than a simultaneous event) which the IRS found objectionable – however, when the case was litigated, T.J. Starker won – giving us the first deferred exchange!

Later, congress issued treasury regulations (1031(a)(3)) which limited the exchange period to just 180 days.

1031 Tip: 2 factors that the court noted – were that T.J. Starker intended these dealings with “Crown Zellerbach” to be structured such that he only received like-kind properties. Moreover, T.J. never handled any cash which supported his argument that this was not a sale – and therefore qualified for 1031 non-recognition treatment.

1031 Exchange Requirements

The complex tax regulations involved in 1031 exchange accounting have been simplified into 3 general rules of thumb called, “The Napkin Test.”

In order to totally defer all of the gain, you must:

·         RULE 1: Trade Up or Equal in VALUE from the relinquished property to the replacement property. (i.e. you purchase a replacement property of equivalent or greater cost)

·         RULE 2: Trade Up or Equal in EQUITY from the relinquished property to the replacement property.  (i.e. you re-invest all of your net proceeds or equity that results from the sale of your relinquished property into your replacement property)

Note For Accountants: If you trade down in value and/or equity, then you will recognizes gain to the extent of the decrease in value or equity, whichever is greater, reduced by standard transactional expenses.

·         RULE 3: You need to OFF-SET ANY DEBT RELIEF on your relinquished property with either: (i) new debt on your replacement property; or (ii) by investing more of your cash in the purchase of your replacement property.

Note For Accountants: Your basis in your replacement property will be the value of your replacement property less the amount of gain you deferred from the relinquished property.  {NEW BASIS = (FMV-GAIN DEFERRED)}

Here is the very technical explanation:

Value Analysis: You must account for any difference in value of your relinquished property in relation to your replacement property.  Exchanging up in value adds to your basis in your replacement property. While Exchanging down (net of standard transactional expenses) means that the you have received taxable boot.

A trade down in value or equity is caused by either:

(i) you have received “boot” in the form of cash (or other non-like kind property) instead of reinvesting your proceeds into your replacement property (trade down in equity);

or

(ii) you received a replacement property of lesser value than your relinquished property by reinvesting all of your proceeds, but incurring less debt on the replacement property than the amount of debt that was discharged in conjunction with the sale of your relinquished property (trade down in value).  If you trade down in either value or equity (net of exchange expenses), then you must recognize gain to the extent of the decrease (up to the amount of your entire realized gain).

Equity Analysis: Next, you must move all of the equity from your relinquished property into the replacement property.  Your Equity is essentially your sales price of the relinquished property less the amount of mortgages, debts or liabilities you had to pay off in order to convey clear title to your buyer.  {EQUITY = (SALES PRICE – MORTGAGE)}

Mathematically your equity has to go somewhere. Your equity will either be:

(i) reinvested in replacement property or used to pay standard exchange expenses (this would be NOT be taxable to you);

or

(ii) received by you as taxable boot, including the use of equity to pay non-standard closing costs that are not exchange expenses (this would be taxable to you).

What’s An Exchange?

Simply put, a 1031 exchange is a tool that allows U.S. taxpayers to defer ALL of the capital-gains tax from the sale of an investment or business-property, such as:

  • Aircraft
  • Artwork
  • Breeding Stock
  • Collector Cars
  • Construction Equipment
  • Drilling Rigs (heavy equipment)
  • Farm Machinery
  • Real Estate
  • Personal Property (used in a trade or business)
  • Telecommunications Equipment
  • etc.

…provided the proceeds are reinvested into the purchase of another “like kind” business or investment property, of equal or greater value.

This is important because when used properly, a 1031 exchange can save youa lot of money!

1031 Tip: To be sure that you’re eligible to receive maximum tax savings – set up your tax exchange early – and priorto the transfer of your old property.

Failure to set up your exchange BEFORE the closing will result in your transaction treated asa sale (rather than an exchange) that you will have to pay taxes on.

Typically, your exchange documentation must be prepared by a Qualified Intermediary (or Q.I.) before you transfer your property.

Cooperation Clause

The reason for adding a Cooperation Clause to your purchase agreement is to alert the other party that you are doing a 1031 exchange, and that they will need to sign some extra documents as part of the closing.

Relinquished-Property

Insert this text when selling:

The Buyer herein acknowledges that it is the intention of the Seller to effect an IRS Section 1031 Tax-Deferred Exchange and that the Seller’s rights under this agreement shall be assigned to Commercial Partners Exchange Company, LLC, to facilitate such exchange. Buyer agrees to cooperate with the Seller and/or its assigns in a manner necessary to enable the Seller to initiate said exchange at no additional cost or liability.

Replacement-Property

Insert this text when buying:

The Seller herein acknowledges that it is the intention of the Buyer to complete an IRS Section 1031 Tax-Deferred Exchange and that the Buyer’s rights under this agreement shall be assigned to Commercial Partners Exchange Company, LLC, for the purpose of completing such exchange. Seller agrees to cooperate with the Buyer and/or its assigns in a manner necessary to complete said exchange at no additional cost or liability.

1031 Tip: Using a cooperation clause helps ensure that you’ll have a smooth and efficient closing by informing everyone of what is expected.

7 Steps To 1031

Step 1.

Determine Your Gain

First you must decide if a 1031 exchange is right for you (or not) by determining the tax-liability when you sell your property outright. More often than not – people find that there is a substantial gain and that it is appropriate to try to perform an exchange to avoid having to pay capital gains tax on the property.

Keep your options open at this early stage – you’ve got 45 days after the day of your closing to identify (in writing) what replacement property(ties) you want to receive as a part of your 1031 tax exchange.

Step 2.

Do You Qualify?

Ask yourself these 2 fundamental questions…

I. Have you held the property for use in your trade, business, or for investment purposes?

If the answer is “yes”, then:

II. Will your exchange be for “like-kind” property?

If you are exchanging real estate for other real estate, the like-kind standard is very flexible. Personal property exchanges however (everything that is non real estate) have much more stringent requirements.

Step 3.

Sign The Purchase-Agreement
To Sell Your Old Relinquished-Property

At this point it's a very good idea to bring your Qualified Intermediary onboard so that he can insert language into the purchase agreement in the form of "a cooperation clause".

Click here for a sample cooperation clause for your relinquished property.

Step 4.

Close On The Sale Of Your
Relinquished-Property

In addition to your closing documents (the deed, closing statement, etc), your Qualified Intermediary will prepare your 1031 documents to be signed in conjunction with your closing.

Typically, you (and the buyer of your property) – will sign the exchange documents at (or prior to) the closing. When you finish with your closing - the proceeds of the sale MUST be sent to your Qualified Intermediary, who then secures them (often in an Federally insured depository) thereby insulating you from receipt of funds.

If you handle (or receive) the proceeds from this transaction in any way, you will have to pay capital gains tax on them.

This is why it is crucial that you involve your Qualified Intermediary before closing.

Step 5.

Identify Your Replacement-Property

In writing, clearly and unambiguously, you must designate the replacement property that you wish to receive – this is typically sent to your Qualified Intermediary within 45 days after closing.

To do this, you fill out an identification form and fax or mail this to the Intermediary - who then stamps it with "received on this date” - files it, and sends a copy back to the seller.1031-Tip: To be sure that you have proof of sending the identification form in, be sure to send it via U.S. Mail so that the envelope is postmarked within the 45 day identification period.

Step 6.

Closing On The Replacement-Property

Closing on the replacement property means MORE than just signing a purchase agreement. It means becoming the OWNER of the replacement property.

For example, in real estate – you typically receive a deed to the property for your transaction to be complete.

Step 7.

Report Your Exchange To The IRS

The 7th and final step is to report your exchange on a form 8824 with your tax-return for the year of the sale.

Your Qualified Intermediary should send you a “summary letter” detailing the information that you will need to complete this form. This form essentially “connects the dots” between the sale of your old property to the sale of your new property.

Click here to download Form 8824

1031-Tip: Do NOT file your tax return before your exchange is completed. It may be necessary to file for an extension to get the full 180 days to which you are entitled – to completed your exchange.

Summary:

Simply put, a 1031 tax exchange was designed to provide U.S. taxpayers with an approved technique that allows the capital gains from the sale of an investment property (be it real estate, construction equipment, breeding stock, airplanes, collectors cars, etc.) to be diverted into the purchase of another “like kind” investment of equal or greater value…

1031 Pitfalls

When Is It Too Late?

Is it too late to initiate a 1031 exchange? If you have closed and received the net proceeds of the sale, it is too late. Once you receive the proceeds it is nearly impossible to unwind the closing. When considering selling an investment property like a farm, ranch, rental property or collectible, one of the first steps is to talk with your accountant to determine whether a 1031 exchange makes sense.

After The 45th Day Can The ID Letter Be Changed?

Can the identification letter be changed after the 45th calendar day? No.

Confirm receipt of the identification letter with your qualified intermediary. The best way to avoid missing the identification deadline is to complete the task by the 44thcalendar day and follow up with the accommodator confirming receipt. Otherwise be sure to send the identification letter by fax to your qualified intermediary no later than 11:59 PM of the 45th calendar day post closing.

Postponing the 45th and 180th Calendar Days

Can the 45th and 180th calendar days be postponed? Yes. Under the following conditions, the identification and replacement periods can be extended.

  • Presidentially declared disasters;
  • Terroristic actions;
  • Military actions or Exchangors serving in combat zones.

Requesting Exchange Funds

You want your exchange proceeds when? The best time to request receipt of exchange proceeds is:

  • At the relinquished or old property closing, take a partial disbursement.
  • If no replacement properties are identified by the 45th calendar day, the exchange is over and exchange proceeds are wired to your bank account.
  • Exchange proceeds are held until the 180th calendar day unless used to acquire replacement property, then wired to your bank account.

Once into a 1031 exchange, the exchange proceeds cannot be received by the exchangor unless at one of the three exceptions described above. Otherwise, the accommodator could be considered an “accommodating accommodator” and taint their third party, independent status.

1031 Terms

1031 Exchange: Internal Revenue Code Section 1031, provides that no gain or loss shall be recognized if property held for investment or for productive use in a trade or business is exchange for like-kind property held for investment or for use in a trade or business.
1031 Exchange Forms: The documents used in a typical 1031 exchange are: (1) Standard Like-Kind Exchange Agreement; (2) Identification of Replacement Property; (3) Assignment of Relinquished Property Contract; (4) Notice of Assignment of Assignment of Relinquished Property Contract; (5) Assignment of Replacement Property Contract; (6) A Notice of Assignment of Assignment of Replacement Property Contract. Also in a reverse exchange, the documentation may include: (1) Qualified Exchange Accommodation Agreement (“QEAA”); (2) Designation or Identification of Relinquished Property. Your Qualified Intermediary will typically prepare and provide the appropriate documentation for you as a part of your exchange.
1031 Exchange Requirements: A 1031 tax-deferred exchange is an approved technique for selling property that has been used for investment or use in a trade or business, and purchasing another like-kind property of greater or equal value without having to pay capital gains taxes. Section 1031 of the Internal Revenue Code states that no gain or loss shall be recognized on the exchange of property that is held for productive use in a trade or business, or for investment purposes (i.e. qualified purpose) if it is exchanged for like kind property that is also held for productive use in a trade or business, or for investment purposes (i.e. qualified purpose).
1031 Properties: Properties that are either disposed of as relinquished property or more typically, replacement-properties that are received to complete a 1031 tax deferred exchange.
1031 Rule: Under Section 1031 of the Internal Revenue Code, persons owning property held for investment or for use in a trade or business can use the proceeds through a qualified intermediary to acquire new property that must also be held for investment or for use in their trade or business. If the transactions are documented and conducted properly as an exchange under Section 1031, the tax payable on any gain from the sale of the property can be indefinitely deferred. Section 1031 provides for the non recognition of gain.
1031 Starker Exchange: The landmark legal decision of T.J. Starker v. U.S., 602 F. 2d 1341 (9th Cir. 1979) was significant in the development of the 1031 tax exchange rules. In this case the Ninth Circuit Court held that non simultaneous 1031 exchanges were permissible and set the precedent for the current 180 day non-simultaneous, delayed tax-deferred like-kind exchange transactions.
1031 TIC: Tenants in Common (or TIC) is a way to hold legal title to property with other co-owners. In legal terms, each co-owner has a distinct title to an undivided-fraction of the whole property. This type of ownership is often referred to as TIC ownership. One advantage of this type of ownership is that upon death, each co-owner can leave his or her distinct fractional-ownership interest to their heirs or successor of their choosing instead of to the other co-owners.
1031 Transfer: A transfer of property as part of a tax-deferred exchange transaction involving property held for trade, business, or investment . See also Deferred Exchange which is closely related. 

3 Property Rule: Exchangor may identify three or fewer replacement properties.  The most common identification rule utilized.

200% Rule: Exchangor may identify any number of replacements; however, the total value of those properties identified may not exceed 200% of the value of Exchangor’s relinquished property.
95% Rule: Exchangor may identify any number of replacements as long as Exchangor receives at least 95% of the value of all properties identified.  Note: This rule is not used very often. 

Adjusted Basis: Adjusted Basis is the net cost of an asset after adjusting for various tax-related items. Adjusted basis is calculated by adding up an asset’s original cost basis, and then making adjustments for additional expenditures for improvements and certain reductions for depreciation and losses. 

Adjusted basis is calculated as follows:

Cost Basis 

+ Purchase costs (title & escrow fees, broker commissions, shipping, sales tax, etc.)

+ Improvements (rehabilitation expenses & substantial repairs)

+ Legal fees (to defend or to perfect title to the property, zoning costs, etc.)

+ Selling costs (title & escrow fees, broker commissions, shipping, transfer fees, etc.)

– Accumulated depreciation, depletion, or amortization

– Casualty or theft Loss

– Other decreases to basis

= Adjusted Basis

Augmented Basis or Substituted Basis: The basis of property transferred in a tax-free exchanges (§1031). The FMV of the new replacement property LESS the amount gain that was deferred. 

Basis: The value of taxpayer’s investment in property.
Boot: Any non like-kind property received by Exchangor during the exchange. 

Build To Suit Exchange: A Build to Suit Exchange (construction improvement exchange) is when the Exchangor wants to construct improvements on the replacement property before the title to the property is transferred to them. The general rule is that you can not construct improvements on property that you already own. Once the Exchangor has title to the replacement property, additional improvements or materials delivered but not constructed are ineligible for 1031 tax deferral. Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 [40 AFTR 648] (7th Cir. 1951) Often the Exchangor will want to make improvements so that they receive finished property that is of equal or higher value than the relinquished property.

Capital Asset: Any asset held by a taxpayer (regardless of its business use) except certain property excluded under IRC Section 1221.  Capital Asset is often held for long-term period and are often tangible property which cannot easily be converted into cash and which is usually held for a long period, including real estate, buildings, machinery, fixtures, furniture and equipment.
Capital Gain: Calculation of the difference between the sales price of the Relinquished Property less selling expenses and less the adjusted basis of the Relinquished Property.
Chattel: Personal property (in contrast to real property) – including tangible movable property (telecommunications equipment, aircraft, trucks, drilling rigs, artwork or farm animals or a heavy equipment etc). Real property is typically fixed to the earth while personal property is moveable.
Capital Gains Tax: Tax imposed is a gain from the sale or disposition of a capital asset. The tax is collected on the gain made selling  (personal property, real property, shares of stock, etc). Capital gains are typically taxed at a lower rate than other income.
Carryover Basis: The basis of property transferred by gift (§1012, §102 or §1041) or in trust, equaling the transferor’s basis.
Cash Boot: Any cash, note or seller carry back received (or not reinvested) by Exchangor during an exchange period.
Chose in Action: An intangible claim or right to sue at law. An ownership interest in or right in intangible property which is not in one’s possession, but which is enforceable through legal process. A personal right of property which can only be claimed or enforced in a court of law, as distinguished from one which is enforceable by the taking of physical possession. Example: A claimant’s right of action in breach of contract proceeding.
Constructive Receipt: Violation of the G(6) limitation wherein the Exchanger obtains direct or indirect control over the exchange proceeds through an agent or employer or other person during the exchange period.
Cooperation Clause: A Cooperation Clause is a provision in a purchase agreement that states that either the buyer or seller wants to conduct a 1031 exchange and reserves the right to assign it’s interest in the purchase agreement to a qualified intermediary. A Cooperation Clausealso typically elicits the other parties (buyer or seller) to assist in signing 1031 documents. If your purchase agreement does not include this Cooperation Clause, the contract can be amended at closing, provided the other parties (buyer or seller) does not object. 

Cost Basis: Taxpayer’s cost of acquiring the property. (§1012) Everything you give to get it.

Deferred Exchange: A Deferred Exchange is typically what people mean when referring to a 1031 exchange, Starker exchange, like-kind exchange, etc. This is A 1031 exchange conducted under the safe harbor 1994 Treasury Regulations wherein the Replacement Property is received up to 180 days after the disposition of the Relinquished Property.
Depreciation Deductions: The tax deduction for writing off the cost of theoretical wear and tear of your property and business-assets over an IRS-specified number of years. Residential rental property is typically depreciated over 27.5 years whereas commercial real estate is typically depreciated over 39 years.
Depreciation Recapture: This is really just capital gains tax applied at a higher rate (maximum 25%) rather than normal appreciation gains (maximum 15%). The federal capital gain rate is currently capped at 15%, the federal depreciation recapture rate is capped at 25%.
Disqualified Person: Section 1.1031(k)-1(k) defines a disqualified person to include an agent of the taxpayer at the time of the transaction. An agent includes a person that has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within two years of the taxpayer’s transfer of relinquished property.
However, in determining whether a person is a disqualified person, services provided by such person for the taxpayer with respect to section 1031 exchanges of property and routine financial, title insurance, escrow, or trust services provided to the taxpayer by a financial institution, title insurance company, or escrow company are not taken into account. Under §1.1031(k)-1(k)(4), a person that is related to a disqualified person, determined by using the attribution rules of sections 267(b) and 707(b), but substituting 10 percent for 50 percent, is also considered a disqualified person.
Direct Deeding: At the direction of the Qualified Intermediary, title passes directly to the ultimate owners without the Qualified Intermediary being in the actual chain of title. 

Exchange Accommodation Title Holder: Also referred to as an “EAT”, is typically a special purpose, limited-liability company that is used to own the legal title to property that is being parked as part of a reverse exchange. An exchange accommodation title holder may not be a person who a disqualified person.

Exchange Fees: To set up an exchange it is usually necessary to hire a Qualified Intermediary. However, the cost of conducting the exchange can be collected on the closing statement – so that the fee is actually paid for with the proceeds of the relinquished property.Exchange fees include preparation of the exchange-documentation, coordination, and communication with the title-company/law-firm that is closing the transaction. The fees for your exchange will range in cost depending on the size and complexity of your transaction.Read More
Exchange Period: Interim time between the disposition of the relinquished property and the earlier of the following:
(i) acquisition of all replacement properties by the Exchangor;
(ii) after the 45 day identification period if an identification has not been made or any identified properties have been previously received by Exchangor or revoked as identified properties;
(iii) after the 180th day following the disposition of the relinquished property;
(iv) after the Exchangors deadline for filing its federal income tax return for the year in which the Relinquished Property was disposed in (including extensions).
Note: The exchange period includes all weekends and holidays. There are no extensions if the exchange period ends on Saturdays, Sundays, or holidays.
Exchangor (Taxpayer): Person intending to conduct a 1031 tax deferred exchange, who transfers a Relinquished Property and thereafter receives a Replacement Property.
G(6) Limitation: Section 1.1031(k)-1(g)(6) provides that an agreement with an escrow holder, trustee or qualified intermediary must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held in the qualified escrow or trust or by the qualified intermediary.
General Asset Class Property: Refers to property described in classes set out in Revenue Procedure 87-56 for depreciable tangible personal property. 

IRS 1031 Exchange: IRC Section 1031 states that “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 for productive use in a trade or business or for investment.”
Identification: Section 1031(a)(3) and Section 1.1031(k)-1(c) provides that a written unambiguous description of the intended replacement property or properties, signed by the Exchangor must be  sent to the qualified intermediary or other person who is a party to the exchange and who is not a disqualified person.
Identification Period: Any Replacements received within the 45 day Identification period are deemed to have been identified.  Replacements received after the 45th day must have been properly identified in writing during the 45 day Identification period. This period runs from the day after the close of the Relinquished Property to the 45th day thereafter. 

Joint Tenancy: A form of co-ownership. Each individual owner in joint tenancy has a right to sell, encumber, and possess the entire property. Regardless of the number of joint tenants, when one joint tenant dies, the remaining joint tenants automatically take the deceased joint tenant’s share of the property by right of survivorship. A principal advantage of joint tenancy is that it allows the surviving joint tenant to avoid probate and death taxes.
Like-kind Property: Exchange must be of “like” property (i.e U.S. real property for U.S. real property OR i.e. light-duty truck for a light-duty truck). Like-kind property is determined by the nature of the property the Exchangor relinquishes and receives in the exchange. 

Mortgage boot: Results when an Exchangor is discharged of a debt obligation with the transfer of the relinquished property and this debt is not offset by either: (i) new debt (assumed or purchase money) of equal or greater amount incurred in conjunction with the closing of the replacement property; (ii) additional cash contributed for the acquisition of the Replacement Property equal to the amount of Exchangor’s debt relief.
Non-Qualifying Property: Property excluded from exchange treatment under IRC §1031(a)(2), such as inventory or property held primarily for sale; beneficial interests in or an ownership in a trust; interests in a partnership; and securities or evidences of indebtedness. 

Partial Tax Exchange: An exchange in which the Exchangor receives some like-kind property and recognizes some gain due to: (i) failure to receive adequately valued Rep