Download 1. Let`s start with the basics- what exactly is a Section 1031

1. Let's start with the basics- what exactly is a Section 1031 Exchange? Section 1031 is
a section of the Internal Revenue Code that permits investment property owners to defer
their taxes (Federal, State and Depreciation Recapture). By doing this, the investor can
reinvest the entire equity thereby increasing cash flow and net worth.
2. Are there different types of Section 1031 exchanges? Yes, there are different types of
1031 exchanges. The most common is a delayed (also called a Starker or forward
exchange). With this type the investor sells their old investment property (Relinquished
Property) first and acquires their new investment property (Replacement Property)
second.
The opposite of a forward exchange is a Reverse Exchange; in this structure the investor
can “acquire” the new property before the old property is sold. However, it must be done
in the manner outlined in Rev. Proc. 2000-37. A special holding entity called an
Exchange Accommodation Titleholder, “parks” one of the properties to facilitate the
exchange and prevent the taxpayer from owning both properties at the same time.
Another type exchange is known as a Build To Suit or Improvement exchange; it is used
when the replacement property is worth less than the relinquished property but the
taxpayer wishes to improve the property using the excess exchange funds. This type of
exchange also uses a special holding entity to hold title while the improvements are being
made. Build To Suit exchanges can also be performed in conjunction with a reverse
exchange.
3. Is all real estate eligible to participate in a Section 1031 Exchange? What is 'LikeKind' Property? Not all Real Estate qualifies for 1031. Only property held for the
productive use in a trade or business or held for investment qualifies for 1031. Properties
that do not qualify are any properties that are held primarily for sale, any personal use
properties such as primary residences and second homes. The definition of “Like-Kind”
is very broad; virtually all fee simple real estate is “like-kind”. For example, vacant land
is like kind to improved land and a single family rental is like kind to a multi story office
building.
4. If I only 'defer' capital gains with a Section 1031 Exchange, when, if ever, do I get
hit with the taxes? The investor will have to pay taxes if they decide to cash out. That
being said, there are many different strategies where an investor can defer the tax their
entire life and then pass the assets on to their heirs without any tax implications.
Investors should consult with their tax advisors how 1031 exchanges can be incorporated
into their estate plans.
5. I have heard there are strict time constraints to do an exchange, what are they?
Generally, from close of escrow the investor has 180 calendar days (not business days) to
find and acquire replacement property. During the first 45 calendar days, known as the
“Identification Period”, the investor must identify to a qualified entity the property or
properties they may acquire by the end of the 180 calendar day time period.
6. Can I select multiple properties as potential replacement properties? What are the
identification rules? Yes, an investor can identify multiple properties. There are two
main rules and one exception. The first rule is the 3 property rule, which allows the
investor to identify any three (3) properties (without regard to their fair market value).
The second rule is known as the 200% Rule. It allows the investor to identify more than
three properties. However, the restriction is that the combined value of all of the
properties identified cannot exceed two times (200% of) the value of the relinquished
property. For example, if the investor is selling a $10 Million dollar property, they could
identify many properties as long as the aggregate of the values did not exceed $20
Million. The 95% exception is often a fall back. If the investor identifies more than
three properties which have an aggregate value which is more than two times the value of
the relinquished property, the investor can still save the transaction if they acquire 95% of
the value of the properties identified within 180 days. Very rarely do we see investors
use the 95% exception.
7. What if I need or receive cash proceeds-can there be a partial exchange? Yes, this is
known as a partially tax deferred exchange. An investor can hold back any amount of
cash that they wish at escrow and allocate the remainder into the exchange. However, the
investor will be taxed on that portion they take as cash.
8. Since I can't take out cash, can I refinance my property beforehand and thus take
the cash tax-free? Unfortunately not. Refinancing before the exchange could be viewed
as a step transaction in order to avoid spending all of the equity from the sale of the
relinquished property. The only scenarios where a refinance before the exchange may
work would be where the investor has a legitimate business reason. An example would
be where the investor needs some cash to get the property ready for sale or maybe a rate
and term refinance. Generally, it is better to refinance after the exchange is completed.
9. The Seller wants to declare certain personal property like stove and refrigerators in
the contract-any effect on a Section 1031 Exchange? Yes, if the taxpayer has
depreciated these assets and wishes to perform a 1031 personal property exchange, it is
possible. They would perform two exchanges. One for the Real property and another for
the personal property.
10. Do I have an issue with any of my closing costs in selling like commissions, title cost,
real estate tax proration’s, security deposits etc. No. A 1031 is just like a regular sale,
the only difference is that the proceeds will be transferred into an exchange account under
the investor’s tax identification number, instead of being transferred directly to the seller.
11. What happens to my tax basis when I participate in a Section 1031 exchange? Very
simply put, the basis is transferred to the replacement property. What the IRS wants to
see is a continuation of the investment. In general, everything stays the same, the only
thing that changes is the asset.
12. What about future depreciation in a 1031 Exchange- how does that work? The
depreciation schedule from the relinquished property is carried to the replacement
property. If the investor purchases a more expensive property, the amount of increase
will create a new depreciation schedule. For example, lets assume the investor sells a
property for $1 Million and purchases a $1.5 Million property as his replacement
property. He will have two depreciation schedules on the new property; the continuation
of the one used on the $1 Million property and a new one for the additional investment of
$500,000.
13. I am a member in a two person LLC, one of us wants to buy a property using a 1031
exchange and the other doesn't-what can we do? Under section 1031 there is a same
taxpayer requirement. The taxpayer that was on title to the relinquished property must be
the same taxpayer on the replacement property. In this particular scenario, there are a
couple of options. The investors could liquidate the partnership prior to the exchange and
distribute to each partner a tenancy-in-common interest in the Relinquished property. It
is advisable to transfer ownership to the individual Exchangers as far in advance of the
exchange as possible (probably a year or more). If a distribution or dissolution occurs
shortly prior to the exchange (or shortly after the exchange), there is an issue of whether
the taxpayer satisfied the “held for” requirement. The “held for” requirement must be
met by the individual Exchanger (former partner) for the exchange to be valid. Another
option might be to perform a partnership division using the rules of I.R.C. §708(b)(2).
It is very important to speak with your tax advisor as soon as possible since there will be
more options containing less risk with advance planning.