Tax-Deferred Exchanges

A Layman's Guide to Section 1031 of the Internal Revenue Code

Includes 1991 IRS Regulations © Copyright 1991, 1994, 1996 Albert J. Velarde 

INTRODUCTION 

• Much has been written over the years to explain tax deferred exchanges, however, it has been my experience that most explanations are lengthy and much too technical. Being a well known real estate attorney with an emphasis in tax deferred exchanges, as well as an author on this subject, it has been brought to my attention that a simple to read guide explaining tax-deferred exchanges has been in high demand for quite a long time. I hope this guide will be useful to you.
  
  

EXCHANGES

• In most of our minds the question lies, "what do the big boys do?? If all of the tax loop holes are for the rich, well, what can the average taxpayer do??" OK, here is the answer we've all been looking for! If you arrange for the sale of your business or investment properties as an "Exchange", such as "trade" properties so to speak, and then reinvest all of the money from your sale into buying more business or investment properties, you will pay NO INCOME TAXES! Yes, its true!
• Also, your income taxes are actually deferred (postponed) until the day you decide to outright sell your property and pocket the sales proceeds. You can even avoid "ever" having to pay the income taxes at all by continuing to exchange properties throughout your entire lifetime! Then, with proper estate planning, you can pass it all to your heirs completely TAX-FREE!!
  

DISADVANTAGES

• There are only two possible disadvantages worth noting. One of them being that you will have a slightly lower depreciation schedule when you acquire your new properties. This is because the IRS will look at your new tax basis as being the same as your previous one; less your deferred gain.
• The other disadvantage is that losses on your income tax return cannot be deducted if you exchange property rather than sell it. So, if you want to take a loss, just call it a sale, not an exchange.

   

WHAT PROPERTIES QUALIFY

• In this area confusion often sets in. Put very simply, any type of real estate used for business, trade or investment purposes will qualify. Examples are: apartments, office buildings, multiplexes, single family or condo rentals, raw land, farms, ranches, commercial, and industrial. All of these will qualify! A lot adjoining a primary residence can also qualify if it is considered investment property.
• MIX & MATCH: You are not limited to exchanging for property similar or exactly like your present property. The law and the IRS allows you to trade raw land for an apartment building or a commercial mall, or a condo rental as long as you structure it as an exchange. As long as you are selling (wanting to exchange) real property used for business, trade or investment purposes; you can buy (exchange it for) any other type of business, trade or investment properties. For example, you can sell your self-operated gas station (trade property) and buy an apartment building (business property) and pay no taxes!

WHAT PROPERTIES DON'T QUALIFY

• Now it is time to talk about IRC Section 1034. This law is in regards to your "personal" residence. The home you live in will not qualify for an exchange because you cannot mix IRC Sections 1031 with 1034. In other words, you cannot sell your home and use the proceeds to buy business or investment property. Nor can you sell business or investment property and buy a primary residence that you intend to live in shortly after acquiring it. EXCEPTIONS AND LOOPHOLES DO EXIST.
• But for now, remember, that all of the properties you sell and buy in an exchange must be trade, business or investment related.

YOU DON'T HAVE TO SWAP

• You do not have to buy property at the same time you are selling. The law allows for what is called a "Delayed Exchange". This lets you sell now and buy your "replacement" property at a later time. However, the law does set up some strict timing requirements which will be explained later.
• There are some interesting ways you can plan your exchange. For instance, you can sell your property to one party and buy your replacement property from another. You can sell one property and buy two, three or more replacements! Here is a good example: if you sell a $450,000 waterfront lot you can buy a $50,000 condo rental, a $100,000 parcel of raw land as an investment, a $150,000 duplex, and a $200,000 commercial building, and PAY NO TAXES!
• Also, you can sell several properties and buy only one property with the sales proceeds. In this instance, you may sell a triplex, a rental single family home and acreage for $400,000 and buy an office building for $500,000 and still pay no income taxes!

HOW TO HAVE A TOTALLY TAX FREE EXCHANGE

• For you folks who like rules and formulas, this section is for you! For those of us that don't, we will keep it simple. So, here it goes... when you sell your property(s), the replacement property(s) must equal or be greater

• than the VALUE (sale price) and existing DEBT of the property(s) being sold (exchanged), and all of your EQUITY from the property you are selling (exchanging) must go into acquiring the replacement property(s).
• The formula is: The replacement property(s) must be equal or greater in VALUE & DEBT than the property(s) being sold (exchanged).

PARTIAL TAX FREE EXCHANGE

• Sometimes you may have a PARTIAL TAX-DEFERRED EXCHANGE. This may happen in a number of ways. Such as pocketing some cash from the sale, or receiving "nonlike-kind" property in the exchange. This "non-like-kind" property could be personal property or any other kind of property different from real estate. Another way to have a partial tax-deferred exchange would be for your replacement property to not be equal to or greater than either the VALUE or DEBT of the property you sold. This means that you will pay some income taxes.
• Any one of the above situations is known as a "PARTIAL TAX-DEFERRED EXCHANGE" because you have not protected all of your sales proceeds from being taxed. For example, if you sell a $200,000 rental and buy two properties totaling $150,000, you may pay income taxes on the $50,000 difference.
• Another example would be if you owned acreage worth $200,000, in which you had $100,000 in DEBT. You decide to sell it!
• You then buy a $200,000 duplex using a $50,000 loan (which gives you a $50,000 in equity). This means you went down in debt by $50,000 which is taxable income. Remember, for a totally tax deferred exchange, you must aquire replacement property(s) which are EQUAL to or GREATER in sales price (VALUE) "and" EQUAL to or GREATER in DEBT than the properties being sold.

PROPERTIES UNDER CONSTRUCTION

• You can acquire replacement properties that will be built for you. However, the construction project must be at a point for all of your equity to be used up and the fair market value equal to the sales price of the property(s) you sold when you acquire title. Completion of the construction project out of your own funds after title passes to you is acceptable.
• Although it is not built, during the 45 day identification period, you must identify this property in as much detail as possible. Also, at the time of acquisition, the construction project must be substantially the same as it was at the time you identified it in detail. Only "usual or typical" construction changes will be allowed.

CONSTRUCTIVE RECEIPT

• If there is a way to foul up your exchange and end up having to pay taxes unnecessarily, this is where it usually happens. For instance, if you or one of your agents (real estate agent or any other person working in your behalf), directly or indirectly, exerts any control over the money received from your sale before the entire exchange is completed, the IRS will DISALLOW THE ENTIRE EXCHANGE.

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  The object of an exchange is to keep you away from the money until you have acquired all of your replacement properties. If your attorney, CPA, real estate broker, escrow officer, or an employee touches the money; in the eyes of the IRS, it is as good as being in your pocket!! This is why you must hire a stranger to act as a "Facilitator", or "Qualified Intermediary" or "Trustee" to handle the exchange.
• The IRS will consider any one who has an existing "AGENCY" or "Fiduciary" relationship with you as being under your control, which in turn, means your money being under your control also. Most state laws automatically consider an escrow officer or closing agent as being your agent, so you cannot use them to hold your money (i.e., hold the proceeds from your sale until you need it to acquire the replacement property).

TIMING REQUIREMENTS We must pay careful attention to the timing rules set up by the IRS. When you sell your property(s) and title passes to the purchaser, the timing requirements to IDENTIFY (locate) and ACQUIRE your replacement property(s) begins. You will have 45 days to produce a written list of up to 3 potential replacement properties (common addresses are OK) delivered to your Facilitator or anyone else that is not your '"agent".

• A signed, dated Earnest Money Agreement is an acceptable alternative to the written list. If you wish to identify more than 3 potential replacement properties, there are only 2 ways to do this:
  
  1. _
  200 PERCENT RULE: You can identify more than 3 properties if all of them add up to no more than TWICE the sales price (fair market value) of the property(s) you sold; or
  
  2. _
  95% RULE: You can identify as many properties as you wish AS LONG AS 95% of the fair market value of all property(s) identified are actually acquired. In other words, if you identify 5 properties worth a total of $100,000 you had better acquire at least $95,000 worth from that list.
• 180 DAY RULE: You must ACQUIRE your replacement properties within the EARLIER of 180 days from closing of the first sale, or, the DUE DATE FOR THE TAX RETURN (including extensions) for the year of the sale.
• WARNING!! If you fail to properly and timely identify your potential replacement properties, or fail to acquire title to all of the replacement properties in time, the IRS could DISALLOW YOUR ENTIRE EXCHANGE.

SUMMARY OF SECTION 1031 REQUIREMENTS 

1  __AN ACTUAL "EXCHANGE" MUST TAKE PLACE. You must either directly swap properties with your buyer's property; or the buyer in exchange for your deed will acquire the replacement property for you; or you must hire an expert to act as the "Trustee", "Facilitator", or "Qualified Intermediary".

• 2. __ THE TRANSFER MUST INVOLVE REAL PROPERTY FOR REAL PROPERTY.
• 3. __ THE PROPERTIES YOU SELL AND ACQUIRE MUST BE HELD FOR PRODUCTIVE USE IN A TRADE, BUSINESS, OR AS AN INVESTMENT.
• 4. __ THE 45 DAY AND 180 DAY MAXIMUM TIMING RETUIREMENTS FOR IDENTIFYING AND ACQUIRING REPLACEMENT PROPERTIES MUST BE MET.
• 5. __ SECTION 1031 IS MANDATORY. If you have accomplished the above 4 requirements, the IRS and the courts will call it an exchange even if you did not intend for it to be so.