Taxpayer. The person or entity carrying out the exchange.
Relinquished Property. The property being exchanged.
Replacement Property. The property being acquired in the exchange.
Buyer. The buyer of the Relinquished Property.
Seller. The seller of the Replacement Property.
Accommodator. The company which holds Taxpayer’s funds between sale of the Relinquished Property and purchase of the Replacement Property.
Exchange Value. The amount of proceeds from sale of a Relinquished Property which a Taxpayer must spend on Replacement Property in order to have a fully deferred exchange.
Realized Proceeds. The sales proceeds received by the Taxpayer from sale of the Relinquished Property including the amount used to pay off the mortgage or deed of trust.
Recognized Proceeds. The portion of the realized proceeds which is recognized as or in
Regulations. The Internal Revenue Service regulations authorizing and regulating deferred exchanges in which the Taxpayer sells the Relinquished Property to a Buyer and acquires Replacement Property from a different Seller rather than exchanging directly.
What is a 1031 Exchange?
An exchange is a real estate transaction in which a taxpayer sells real estate held for investment or for use in a trade or business and uses the funds to acquire replacement property. A 1031 exchange is governed by Code Section 1031 as well as various IRS Regulations and Rulings.
Section 1031 provides that “No gain or loss shall be recognized if property held for use in a trade or business or for investment is exchanged solely for property of like kind.” The first provision of a federal tax code permitting non-recognition of gain in an exchange was Code Sec. 202(c) of the Revenue Act of 1921. Section 1031 has existed in the Internal Revenue Code since the first Code in 1939. It remains identical with only two additions in more than 75 years.
Section 1031 on its face appears to permit only a direct exchange of properties between two taxpayers. Following the decision in 1979 in Starker v. U.S. taxpayers were permitted to structure deferred exchanges in which the taxpayer sold the Relinquished Property to a buyer and acquired Replacement Property from a seller using the Realized Proceeds. Deferred exchanges are often called “Starker” exchanges. The Internal Revenue Service challenged deferred exchange but the Tax Court was liberal in allowing them and in 1991 the Internal Revenue Service adopted Regulations permitting them and governing their structure.
How is a 1031 Exchange Structured?
Before closing of the sale of the Relinquished Property, the Taxpayer must enter into an exchange agreement with an Accommodator and the Buyer. The Accommodator holds the Taxpayer’s net Realized Proceeds until purchase of the Replacement Property and the Taxpayer is prohibited from receiving, pledging, borrowing or otherwise receiving the benefits of the funds.
The Taxpayer’s contract rights are assigned to the Accommodator, a requirement of the Regulations which allows the Relinquished Property to be conveyed directly to the Buyer. Prior to the Regulations, taxpayers conveyed both the Relinquished Property and the Replacement Property to the Accommodator in order to emulate a direct exchange, but the Regulations substituted the assignment requirement and made clear that this was not necessary.
The Taxpayer will enter into a contract with the Accommodator to hold the funds between transactions in addition to the exchange agreement. When the Relinquished Property is sold, the funds are transferred to the Accommodator which holds the funds and transfers to the escrow for purchase of the Replacement Property.
The exchange funds can be used only to buy Replacement Property, pay closing costs or pay off a mortgage or deed of trust covering the Relinquished Property. Exchange funds cannot be used to pay off other debts or loans which are not secured by a mortgage or deed of trust of the Relinquished Property without recognizing gain.
How are mortgages on the relinquished property treated?
A mortgage or deed of trust on the Relinquished Property can be paid off with exchange proceeds. The portion of the proceeds used to pay the mortgage or deed of trust are deemed Realized Proceeds, however and are included in the Exchange Value, so the mortgage must either be replaced with a new mortgage or cash in purchasing of the Replacement Property.
If the Taxpayer borrowed funds to purchase the Relinquished Property, the loan cannot be repaid out of exchange funds unless the loan was secured by a mortgage or deed of trust on the Relinquished Property.
A Taxpayer cannot take back a note in partial payment of the purchase price of the Relinquished Property without recognizing gain because a note is treated as other property, not Replacement Property.
What tests are applied to determine if properties qualify in an exchange?
Qualified Use Test
Both the Relinquished Property and the Replacement Property must be held either for use in a trade or business or for investment. “Held for investment” means that if the property is improved, it must be rented. That means that a Taxpayer who allows his children to live in property rent-free or a Taxpayer which holds the property but does not rent it is not holding it for investment. Vacant land generally cannot be rented and it will be deemed held for investment if it is held for increase in value.
Like Kind Test
The Replacement Property and Relinquished Property must be “like kind” which is very broadly interpreted and means that both must be held either for use in a trade or business or for investment, but the properties do not have to be similar in service or related in use. A condominium can be exchanged for a single-family dwelling or a shopping center for an office building. Any investment or business property can be exchanged for any other investment property or business property.
Leaseholds and Coops
A leasehold is like kind with a fee only if has more than 30 years of term remaining, including options to renew (whether or not renewed). A coop is not real estate in the conventional sense; rather it is stock in a corporation which owns the land upon which the project is located and a space lease of the apartment. A coop is deemed real estate in jurisdictions which recognize it as such however, so it can be exchanged, but it is treated as leasehold property, so if the apartment lease has less than 30 years of term, it can only be exchanged for a leasehold.
What are the tax consequences of an exchange?
An exchange is not tax-free as it is often described; rather it is tax-deferred because the Taxpayer carries over its tax basis in the Relinquished Property to the Replacement Property. This means that the gain realized in the exchange transaction will be recognized if the Taxpayer does not exchange when he sells the Replacement Property.
Basis in the Replacement Property is increased by any gain recognized on the sale of the Relinquished Property or by capital improvements installed after purchase and is also increased by the amount Taxpayer spends in excess of Exchange Value when acquiring the Replacement Property.
Exchange value is the gross selling of the Relinquished Property minus deductible costs of sale but including the amount used to pay off the mortgage or deed of trust. Deductible costs of sale are items which would be deductible if the transfer were a sale and not an exchange such as
- Broker’s commissions
- Escrow and title fees Attorneys’ fees Accommodators’ fees
- Fix-up expenses which would be deductible if sold
- Closing costs on the purchase of Replacement Property are added to the amount spent for purposes of determining if the Taxpayer has spent her Exchange Value. Loan fees and prorations are not deductible and do not reduce exchange value or increase the amount deemed to have been spent on the Replacement Property.
Boot is gain realized in an exchange. Taxpayers can generate boot in five ways:
- Taking out cash from proceeds of sale
- Spending less than the exchange value on the Replacement Property
- Not replacing debt paid off on the Relinquished Property. Because the portion of proceeds used to pay debt is deemed realized, the Taxpayer must replace it either with new debt or cash in purchase of the Replacement Property in order to avoid recognizing it.
- Over-mortgaging the Replacement Property. For example: the Taxpayer sells Relinquished Property for $500,000 with a $100,000 mortgage and buys Replacement Property for $500,000 but obtains a $200,000 mortgage The excess mortgage proceeds of $100,000 is recognized as gain.
- Paying debts not secured by a mortgage or deed of trust on the Relinquished Property.
How and when is replacement property identified?
The deferred exchange regulations require that within 45 days of closing of sale of the Relinquished Property the Taxpayer must identify Replacement Property. This is usually done by letter to the Accommodator. Within 180 days of closing of sale of Relinquished Property, or before the Taxpayer’s next tax return is due, the Taxpayer must acquire the Replacement Property. These deadlines are absolute and cannot be changed or extended.
The Regulations allow identifying multiple properties. A Taxpayer may identify as many as 3 alternate properties of any value. If more than 3 properties are identified, the value of the 3 cannot exceed 200% of the value of the Relinquished Property unless 95% of the properties identified are acquired. If any of the rules are not followed, the Taxpayer will be treated as not having identified any Replacement Property.
If three properties are identified, the Taxpayer can acquire one or more of the properties, and can acquire multiple replacement properties. Carryover basis is allocated pro rata to the purchase price of all properties acquired.
A Taxpayer can sell multiple relinquished properties and buy multiple replacement properties. If several Relinquished Properties are sold the time for identification and purchase of Replacement Property will begin at the time of each sale so it might be wise to structure an exchange of multiple Relinquished Properties so that each are exchanged separately and each has its own time deadlines for identification and acquisition of Replacement Property.
What is a reverse exchange?
A reverse exchange is a transaction in which the Taxpayer has located Replacement Property he wishes to acquire, but has not sold his Relinquished Property. In a reverse exchange, the Taxpayer acquires the Replacement Property by “parking” it with an accommodator until the Relinquished Property can be sold. This is done by forming a single-member LLC of which the accommodator is the member. The LLC and the Taxpayer enter into a contract providing for the LLC to hold the property until the Relinquished Property is sold and then to exchange it for the Replacement Property in a forward exchange.
While the accommodator holds the Replacement Property, it must pay all expenses and treat the property as if owned by it, not by the Taxpayer and the Accommodator will require that the Taxpayer deposit amounts sufficient to cover insurance premiums, property taxes and any other expenses of ownership, but the Taxpayer is permitted to lease or manage the property. If the Taxpayer leases it, the lease could provide for the Taxpayer to pay taxes or buy insurance so management is simpler and is directly at the expense of the Taxpayer
In order for the LLC to acquire the Replacement Property in a reverse exchange, the Taxpayer must loan the funds necessary for purchase to the LLC because the Taxpayer will not have the proceeds of sale of the Relinquished Property. The LLC will give the Taxpayer a note secured by a mortgage or deed of trust of the Replacement Property to document the loan. The Taxpayer can mortgage either the Relinquished Property or the Replacement Property, or use a home equity line of credit to generate the funds necessary for purchase. If the Taxpayer mortgages the Replacement Property the mortgage will be given by the LLC and will be non-recourse, but the note can be signed by the Taxpayer.
When the Relinquished Property is sold, the Taxpayer and Accommodator enter into an exchange agreement, and the proceeds are used to pay off the note so the Taxpayer gets back the cash loaned for the purchase. The LLC membership interest can be conveyed to the Taxpayer rather than the property thus avoiding a second transfer tax.
Can a taxpayer exchange with a related party?
Related party transactions are an enigma under many provisions of the Internal Revenue Code. Section 1031(f) provides that if a Taxpayer exchanges with a related party then the party who acquired the property in the exchange must hold it for 2 years or the exchange will be disallowed. Related parties are linear blood relatives and entities in which the Taxpayer owns an interest, but also include some complex relationships with trusts and entities.
The related party rules are complicated by Section 1031(f)(4) which provides that if a Taxpayer attempts to avoid the 2-year rule by structuring an exchange to avoid it, then the exchange is disallowed. The example of such a structure in the legislative history is if the seller sells the Replacement Property to the Buyer of the Relinquished Property, and the Buyer exchanges the Replacement Property for the Relinquished Property with the Taxpayer, then the Taxpayer will not be subject to the 2-year rule because she would not have exchanged with a related party. This is the only structure which could have this result yet the Tax Court ruled in a case (and there have been several since as well as some IRS rulings) that a Taxpayer which used an accommodator to hold funds in an exchange was essentially trying to avoid the 2-year rule by “exchanging” with a third party which was not a related party.
The effect of this case is to eliminate the possibility of a Taxpayer acquiring Replacement Property from a related party even if the Taxpayer holds the Replacement Property for 2 years as required by the Code.
How do partnerships exchange?
Taxpayers cannot exchange partnership interests or acquire a partnership interest in a partnership which owns real estate except an interest in a single-member LLC (single member LLCs are disregarded for tax purposes and treated as if the sole member owns the real estate).
Multi-member LLCs and partnerships are not disregarded for purposes of an exchange. Thus, if a partnership owns real estate and wants to exchange it is the partnership or LLC which must exchange not the partners. The Partnership must acquire the Replacement Property.
What if some partners want to exchange and some do not? This can be done in three ways:
- The partnership can dissolve before selling the Relinquished Property, distribute pro rata shares to the partners, and each can sell or exchange.
- The partnership can acquire multiple Replacement Properties and then dissolve, distributing the properties to the partners in redemption of their interests.
The partnership can exchange, spend less than the exchange value, recognize the gain and specially allocate it to the partner who doesn’t want to exchange, then distribute the cash to that partner in liquidation of his partnership interest.
An exchange is a very useful planning tool which allows maximizing returns on investment by allowing a Taxpayer to invest all proceeds of sale and defer capital gains taxes. If continued through a Taxpayer’s lifetime it is a great estate planning tool because the Taxpayer’s heirs will get the property with a basis stepped up to fair market value at the Taxpayer’s death and then can sell without recognizing any gain.