Martha (Marti) Read
Broker / Salesperson
Direct: 800-708-5794
Cell: 609-206-4253
marti@stoneharbor.com

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BENEFITS OF TAX DEFERRED EXCHANGE

The following is intended as a primer on the guidelines and restrictions set forth in Section 1031 of the Federal Tax Code, along with some illustrations of various types of tax- deferred exchanges. Hopefully, some common misconceptions about exchanging will be cleared up and encourage a property owner to take advantage of the practice. However, the decision to employ any of these strategies can only be made after an individual's overall tax "picture" is viewed by their CPA or tax lawyer.

Important Note: Whenever contemplating a tax exchange all relevant documents, i.e. Real Estate contracts, must indicate your intent to complete said exchange.

TAX-DEFERRED EXCHANGES - AN OVERVIEW

Although most homeowners are aware of the up to $500,000 primary home exclusion provided under the Federal Tax Code, surprisingly few real estate investors (many being the same individuals) are aware of the advantages and significant tax savings afforded by IRS Section 1031 . This is the section of the code that authorizes and sets forth the requirements for "tax- free exchanges", also known as "tax- deferred exchanges".

A tax-deferred exchange is a procedure in which a real property owner trades one property for another without having to pay any federal income taxes on that transaction. Under normal circumstances, the selling owner would be taxed on any gain triggered by the sale of his or her property. However, in an exchange, the tax on the transaction is deferred until a future event; usually the sale of the newly acquired property. Rather than a simple sale of one property and purchase of another, this same sale and reinvestment are carefully structured as an exchange via an exchange agreement and most often, the services of a qualified intermediary. The intermediary, for a fee, helps ensure the exchange is structured property.

BENEFITS OF A TAX DEFERRED EXCHANGE

The most obvious benefit of a tax-deferred exchange is the ability to settle property without having any present tax liability. The monies that would have normally been paid to the IRS, instead, continue working for the taxpayer in the next investment property. These dollars can be compounded through a series of subsequent exchanges, with the tax liability ultimately being forgiven upon the death of the taxpayer and without his or her estate having to pay. Any heirs would acquire a stepped up basis on the inherited property , equated to the fair market value at the time of the taxpayer's death.

REQUIREMENTS FOR TAX DEFFERED STATUS

The reality of "exchanging" is that the IRS regulations make the practice relatively simple and inexpensive. However, certain requirements must be met in order for a transaction to achieve tax-deferred status under Section 1031. The following paragraphs outline the most essential elements.

Real property is the usual asset in a tax-deferred exchange, though not all real property is eligible for such treatment. Qualified real property is that which is "held for productive use in a trade or business or for investment". Essentially any real property other than one's personal residence or "dealer" property (acquired for the specific purpose of resale) would pass the litmus test.

An additional and related consideration is how long a taxpayer must hold the property in order for it to qualify for tax-deferred treatment. This test applies to both the relinquished (sold) and replacement (purchased) properties, with their respective holding periods helping to establish validity of "purpose". If, for example, a property is acquired and immediately resold, it may be deemed dealer property and unqualified for tax-deferred treatment. A one year holding period, on each, always been a general rule-of-thumb.

Further, the replacement property that would be acquired in an exchange must be of a "like-kind" to the property being relinquished. Like kind is defined as "similar in nature or character, notwithstanding differences in grade or quality". Basically, all real property is like-kind. One property may be exchanged for more than one property, a duplex may be exchanged for a triples; a single family home may be exchanged for an office building. The cardinal rule is that real property may not be exchanged for personal property, and that the real property be held for business or investment purposes.

Also, in order for an exchange to be totally tax-deferred , the replacement property must be of greater value than the one being relinquished, with all equity being applied towards the acquisition of the replacement property.

LIMITATIONS ON TAX-DEFFERED EXCHANGES

Since Section 1031 requires that an exchange rather than a sale and purchase for cash occur, there are strict limitations on the flow and handling of funds. The taxpayer cannot actually receive proceeds in the exchange transaction. He or she may not even have control of the funds (i.e. credit to his/her account, set aside, or made available for future access). This principle is that of the "constructive receipt", and its occurrence would invalidate an exchange. Even though the taxpayer/exchanger is entitled under Section 1031 to have security for his or her funds along with any interest earned on them, their access and control must be "substantially limited and restricted". This oversight is usually assigned to the qualified intermediary , who establishes an escrow account pending the completion of the exchange transaction.

RESTRICTIONS ON DEFFERED OR NON-SIMULTANEOUS EXCHANGES

Unlike holding period timing, there are hard fast time restrictions in any deferred or non-simultaneous exchange. Closing of old property being sold/relinquished by the taxpayer activate two time clocks.

First , the taxpayer must identify (in writing) up to three replacement properties within 45 days of the sale of the relinquished property.

Second, the actual settlement on the replacement property must take place on the earlier of (a) 180 days after the closing of the relinquished property, or (b) the due date of the taxpayer's federal income tax return (including extensions) for the year in which the relinquished property is transferred.

Simultaneous exchanges, although less common, do take place and would not be subject to these time restrictions. (As the foregoing would suggest, a normal exchange involves relinquishing one property and replacing it with another.)

 

TAX-DEFERRMENTS ON REVERSE EXCHANGES

Reverse exchanges, on the other hand, allow the taxpayer to first acquire the new property and then sell the old one, later. Although Section 1031 does not specifically define rules for a reverse exchange, they are routinely employed and are structured within the guidelines and time restrictions of a standard exchange. There are two basic formats for a reverse exchange, both of which require an intermediary to take title to at least one exchange property and also accept the burden of actual ownership (i.e. make mortgage, tax and insurance payments, collect rents, etc.)

The more common format is to have the intermediary purchase the new property with funding provided by or arranged for by the exchanger.   The intermediary holds the title until the taxpayer/exchanger sells the old property, at which closing the intermediary deeds the new property to the exchanger. The second, less common type of reverse exchange, is one in which the exchanger purchases the new property and simultaneously deeds the old property to the intermediary. When the old property is sold, the intermediary deeds it to the new buyer and passes the sale proceeds to the exchanger. This scenario requires the exchanger to place a down payment on the new property approximating the amount of cash proceeds that would be realized from the sale of the old property.

The final, less common, and somewhat more complicated exchange variation is an Improvement Exchange. It is similar to a reverse exchange in that an intermediary takes title to the new/replacement property while capital improvements are being made to it. Once the improvements are completed, title then passes to the exchanger. Usually, the old/relinquished property will have been sold to fund the purchase of the improvements to the new one. However, the exchanger could fund the purchase of and improvements to the new one. However, the exchanger could fund the intermediary's acquisition and construction of the new property prior to selling the old one. Both formats would have the intermediary taking title during construction with disbursements to suppliers and contractors being facilitated through an escrow account. When completed, the property would be conveyed to the exchanger from the intermediary.

Important Note: Whenever contemplating a tax exchange all relevant documents i.e. Real Estate contracts must indicate your intent to complete said exchange.

 

REVERSE EXCHANGES BLESSED BY I.R.S.

The Internal Revenue Service issued Revenue Procedure 2000-37 on September 15, 2000; to provide a safe harbor for taxpayers engaged in deferred (reverse) exchanges of property. Under Internal Revenue Code Section 1031, an exchange of like-kind property used for business or investment purposes is not taxable.

In recognition of the decision of Starker v. United States 602 f.2d 1341 (9th Cir. 1979), The Internal Revenue Code allows reverse exchanges of property if, at closing (the "Closing"), the taxpayer transfers property (the "Exchanger Property"), identifies the like-kind property or properties to the acquired (the "Replacement Property") within forty-five (45) days of the Closing, and acquires the Replacement Property within one hundred eighty (180) days of the Closing.

In the past, the IRS has not approved tax-free treatment for "reverse starker" exchanges. A reverse Starker exchange is one in which a plan exists to acquire the Replacement Property before the taxpayer transfers the Exchange Property. Revenue Procedure 2000-37 acknowledges that taxpayers have engaged in "parking" transactions to facilitate reverse Starker exchanges. In essence, the taxpayer "parks" the Replacement Property with another party (the "Accommodating Party"), who holds the Replacement Property until the taxpayer identifies someone who will acquire the Exchange Property. Once the acquiring property is identified, the taxpayer engages in a tax-free exchange with the Accommodating Party, who then transfers the Replacement Property to the taxpayer.

 

ACCOMODATION PARTY MUST OWN PROPERTY

In revenue Procedure 2000-37, the IRS held that it would treat a reverse-Starker exchange as a tax-deferred exchange if and only if the Accommodating Party obtains sufficient legal rights in the Replacement Property so as to be treated as the owner for federal tax purposes. The Revenue Procedure assists taxpayers with a "genuine intent to accomplish a like-kind exchange" by providing a safe harbor in which the Accommodating Party will be treated as the owner of the property for tax purposes. Revenue Procedure 2000-37 requires that the Accommodating Party enter into a written "qualified exchange accommodation arrangement" (QEAA) with the taxpayer.

 

The IRS requires the following:

1. 

The Accommodating Party must hold legal title to the Replacement Property and also hold other indicia of ownership.

2. 

The Accommodating Party must be taxable. If the titleholder is a partnership of a corporation, ninety (90) percent of its interests must be owned by taxable parties.

3. 

When ownership of the Replacement Property is transferred to the Accommodating Party, the taxpayer must have a bona fide intent to engage in a tax-free exchange involving that property.

4. 

Within forty-five (45) days after the transfer of the Replacement Property to the Accommodating Party, the taxpayer must identify the Exchange Property to be transferred. The taxpayer may identify alternative and multiple properties.

5. 

Within one hundred eighty (180) days after the taxpayer transfers the Exchange Property, the Replacement Property must be transferred to the taxpayer.

6. 

The time period between the Accommodating Party's acquisition of the Replacement Property and the actual exchange with the taxpayer cannot exceed one hundred eighty (180) days.

7. 

Within five days after the Replacement Property is transferred to the Accommodating Party, the taxpayer and the Accommodating Party must enter into a QEEA.