1031 EXCHANGES: FAQ's

This information compiled and written by :
Cheri A. Lewis, Esq. of Keeler Obenshain, PC
434.295.3794
clewiscville@ntelos.net

© Cheri A. Lewis, Esq. 2005

What You Need to Know

“1031” or Deferred Like Kind or “Starker” Exchange Defined:

History: Since 1921, the IRS has treated the exchange of property as a non-taxable event, subject to certain regulations. Originally, the exchange or trade between taxpayers had to be simultaneous, which presented challenges. In 1979 in the Starker case, the 9^th Circuit Court of Appeals upheld non-recognition of an exchange, stating that there was not a requirement that the exchange be simultaneous. Congress responded in 1984 by enacting Section 1031 of the IRS Code, sanctioning a transaction that is deferred, where a taxpayer may sell property and not incur capital gains liability by later acquiring another property.

The Definition of a 1031 Deferred Like Kind Exchange: A transaction where property used in a trade or business or held for investment is exchanged solely for like-kind property which will be used in a trade or business or held for investment, without the imposition of capital gains tax.

How a 1031 Exchange Works: In the First Leg transaction, the Taxpayer sells the Relinquished Property to a Buyer and the remaining Cash (“boot”) is sent to a Qualified Intermediary. The Qualified Intermediary holds the Cash in escrow while the Taxpayer identifies the Replacement Properties and prepares to acquire them by closing within 180 days. At the Second Leg, the Intermediary Pays the Cash to the Seller so that the Taxpayer acquires title to the Replacement Property.

Types of 1031 Exchanges: Simultaneous (rare), Deferred or Starker, and Reverse (Replacement Property bought before Relinquished Property sold).

What are The Tax Benefits of a 1031 Exchange? Two Tax Benefits:

    1) The Taxpayer defers capital gains tax by successfully completing a 1031 Deferred Like Kind Exchange so Taxpayer has the use of the cash that otherwise would have gone to the IRS.
    2) The Taxpayer defers capital gains on the tax due on the recapture of depreciation previously taken by the Taxpayer during the period of ownership.

The Additional Financial Benefit: The Taxpayer has made more proceeds from the sale of the Relinquished property and can leverage that additional cash to increase his buying power in the second property (the second property acquires a larger acquisition).

Some commentators say that a 1031 provides an Interest Free Loan courtesy of Uncle Sam. Tax is deferred, but no interest is due on the use of the cash until the ultimate sale of the Replacement Property where capital gains ultimately recognized.

See Article: 1031 Exchange, an “Interest Free Loan,” What Does that Really Mean? by Linda J. Rehak, V.P, Underwriting Counsel, LandAmerica Exchange Company.

What is a “Qualified Intermediary” and Why Your Clients Need One?

Defined: Also known as a “Facilitator”: The party who holds the Cash or “boot” and accommodates the exchange by acquiring and selling the involved properties to help the Taxpayer complete the 1031 transaction according to the various IRS regulations. Typically, they can be exchange service companies, attorneys, or CPA’s. They should be knowledgeable and experienced in accomplishing these sophisticated transactions.

The Qualified Intermediary will provide the documents such as the Identification Forms, Notification Letters, and the Escrow Agreement, which is the most important document. Because the IRS regulations governing time periods and notices are very strictly construed, it is important that the Intermediary by highly organized to prompt the Taxpayer during the process. The Qualified Intermediary receives the proceeds from the First Leg, preventing the Taxpayer from direct or indirect receipt of the funds, which would invalidate the transaction. The Intermediary then holds the Cash in escrow in and ensures that there is a small return of interest during the escrow period.
LandAmerica Exchange Services can act as a Qualified Intermediary for your clients.

What are the “45 Day” and “180 Day” Rules?

45 Day Rule: Under IRS Regulations, a Taxpayer has 45 days from the sale of the Relinquished Property to identify in writing, with notice given to the Qualified Intermediary, of the identification of up to three possible replacement properties.

180 Day Rule: Under IRS Regulations, a Taxpayer has 180 days from the date of the sale of the Relinquished Property OR the date of the Taxpayer’s federal tax return, whichever occurs first, to acquire one or more of the identified properties.

What is the “3 Property Rule” and the “200% Rule”?

3 Property Rule: The Taxpayer must identify three (3) properties to acquire within 45 days of selling the Relinquished Property. The Taxpayer is not required to purchase any or all of them, but must simply identify three properties by written notice to the Qualified Intermediary.
See Article: Complying With the Three-Property Identification Rule: Is This One or Three Properties? by Linda J. Rehak, V.P, Underwriting Counsel, LandAmerica Exchange Company.

200% Rule: The Fair Market Value of the three (3) properties combined must not exceed 200% of the fair market value of the Relinquished Property.

What Do I Need to Know About “Constructive Receipt”?

Constructive Receipt or Receipt is where the Taxpayer indirectly or directly receives in his possession the proceeds from the First Leg transaction from the Relinquished Property. This invalidates the 1031 benefits immediately. Like all regulations governing 1031 Exchanges, this rule is very strictly construed.

What Do I Need to Know About This? If your client is trying to accomplish a 1031 Exchange, in the First Leg transaction, their settlement agent cannot received the net proceeds at closing. That would amount to Constructive Receipt. The proceeds from the buyer must be wired directly to the Intermediary or the check made payable to the Intermediary. This is why it is very important that the settlement agent be informed very early about the 1031 transaction.

What Kind of Property Can Be Exchanged?

Any property used in trade or business or held for investment purposes. It can be real property or personal property (a boat).

What cannot be:

1) Primary residences or any property converted for personal use cannot be exchanged.

2) Real estate held primarily for sale as inventory (houses that a builder might construct in his trade).

3) Real estate located outside the United States.