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1031-Tenants in Common - FAQ
1031 exchange FAQ
1031 exchange Question - What is a tax deferred exchange?
A. A tax deferred 1031exchange is a transaction involving trade, business, or investment 1031 property
, which, because it meets the requirements of Section 1031 of the Internal Revenue Code, qualifies for non-recognition of gain or loss. It is a technique for deferring gain on the sale of property by re-investing the proceeds of the sale in "like-kind" property. The theory is that if one does not cash out of an investment (having rolled over proceeds into new like-kind property), the economic gain has not been realized in a way that produces the cash to pay the tax, and, as a result, no tax should be due.
1031 exchange Question - Do I permanently escape the capital gains tax?
A. No, not unless you die. The like-kind 1031 exchange rule is a tax-deferral technique. The new tenants in common property purchased with the proceeds from the sale of old property has the same low tax basis as the old property. When the new property is later sold, the original deferred gain, plus any additional gain realized since the purchase of the new property, is subject to tax. Of course, one can sell the new property as part of another like-kind 1031 exchange and continue to defer their capital gains tax.
1031 exchange Question - And what if I die?
A. That is when the deferral may turn into permanent tax savings. Upon your death, the basis of property gets "stepped-up" to fair market value and the capital gain may not be taxed. Under current tax rules. those who inherit the property can sell it at fair market value at date of death and not pay tax on the gain. Thus the
1031 exchange
tax strategy "'swap' till you drop" may have merit. It is always recommended that any potential exchangers seek the advice of their tax professional, however. TIC Advisors does not offer tax advice.
1031 exchange Question - What type of property qualifies for a 1031 exchange?
A. If the relinquished 1031 property was "held for investment" or "for use in a trade or business," and the replacement 1031 property will he held for similar use, you can affect a tax-deferred 1031 exchange. Virtually any real estate is like-kind to any other real estate (such as vacant land for a strip shopping center, an office building for an apartment building, etc.). Personal-use property (e.g., a principal or secondary residence) and property held for speculation, resale, or development does not qualify under Section 1031.
1031 exchange Question - What is a Qualified intermediary?
A. A qualified intermediary is an independent agent that facilitates a 1031 exchange. The taxpayer's attorney or accountant cannot be a qualified intermediary. Most intermediaries are affiliated with banks, trust companies, or title companies. Using a qualified intermediary is one way of "safe harboring" a 1031 exchange
. Essentially, the qualified intermediary takes an assignment of rights in the sale contract for the old property and the purchase contract for the new property. These are documents that the investor or his/her attorney completes, along with a basic exchange agreement with the intermediary. Through these three documents, the intermediary is brought into the
1031 exchange and, subject to compliance with the timing rules discussed below, the transaction can qualify as an Exchange rather than a taxable sale.
1031 exchange Question - What does a QUALIFIED INTERMEDIARY do with the money?
A. The most important role of the qualified intermediary is to hold the proceeds of sale pending reinvestment in new property. The Internal Revenue Service takes the position that if the seller receives (or has direct or indirect use of or control over) the proceeds of sale, then the tax payer is constued to have taken "contructive receipt" and is therefore required to pay the tax. By arranging for the qualified intermediary to hold the money, the taxpayer never receives the cash, and therefore the transaction can be viewed as a
1031 exchange.
1031 exchange Question - How much time do I have to locate and obtain my replacement 1031 property?
A. When structuring a tax-deferred exchange, two time limitations are of critical importance. The 1031 Exchange Rule specifies that the period of time during which you must identify and the period of time during which you must acquire your replacement 1031 property is within 45 days of the closing on the sale; within this time, the taxpayer must "identify" the new property. One must close on one or more of the identified replacement 1031 properties within 180 days of the date of closing on the old property. This is not 45 days plus 180 days. The 45- and 180-day periods run concurrently. The 180-day period is cut short if the tax return filing deadline comes up before the end of that period; one can get the full 180 days, however, by extending the time for filing the tax return.
1031 exchange Question - What if I miss a deadline?
A. Tough luck. Generally, there can be no extension of either of these time periods. If the 45th or 180th day falls on a Saturday, Sunday, or legal holiday, the identification and the exchange period are usually not extended to the next business day.
1031 exchange Question - How do I identify the replacement 1031 property?
A. The Internal Revenue Service regulations set strict guidelines to satisfy the identification requirement. The identification must be specific (such as the address of property or legal description). Identification is made by sending the qualified intermediary written notice of the targeted new property.
1031 exchange Question - How many properties can I identify?
A. The IRS regulations place restrictions on the number of 1031 properties that may be identified during the identification period. The taxpayer may designate more than one property (generally up to three, or more than three if the total value of the new properties designated is less than twice the value of the property sold). One can also identify fractional interests in property that will be held in a co-tenancy. However, if, at the end of the identification period, you have identified more properties than permitted, you are treated as if no replacement 1031 property
had been identified. Accordingly, the tax-deferral exchange treatment may be denied.
1031 exchange Question - What is a reverse 1031 exchange?
A. As of September 15, 2000, reverse 1031 exchanges (when the new property is purchased before the old property is sold) are permitted. However, you must use a special "parking intermediary" to purchase and hold the new replacement 1031 property until the old property is sold. The old property sale can be structured as a normal "forward" exchange where the proceeds are rolled over into the new property being "warehoused" or "parked" with the parking intermediary. The parking intermediary can hold the new property for up to 180 days.
1031 exchange Question - What about newly- constructed property?
A. One can trade into newly-constructed property, but one cannot own the land on which the improvements are being built. The land must be owned by the seller, the developer, or a parking intermediary. If the taxpayer already owns the land, it can be sold to a parking intermediary or the developer. The seller or intermediary will contract to construct the improvements, and at the end of the 180 day period can convey the property (completed or partially completed) to the taxpayer to close out the 1031 exchange. This is usually a race against the clock to try to spend as many construction dollars as is necessary to complete the trade. One cannot prepay construction costs.
1031 exchange
Question - How do I "rollover" to defer paying the capital gains tax?
A. The essence of a trade is that one has not cashed out any part of the investment. One must trade up or even on price. In addition, one must use all of the cash proceeds from the sale. The transaction is taxable to the extent that the purchase price of the new replacement 1031 property is less than the selling price of the old property. The transaction is taxable to the extent that there is cash left over with the qualified intermediary after the purchase of the new property. If one trades up or even in price and uses all the cash, then the debt (comparing the mortgage on the old property to the mortgage on the new property) should be roughly the same or greater. If the debt goes down, there is a potential tax unless more cash is put into the deal. One cannot borrow more on the new property as a way of trading up and taking cash out of the deal. Again, all potential exchangers should speak with a tax professional to see if a 1031-TIC exchange would be a suitable tax solution for their individual situation.
1031 exchange Question - How do I get my equity out?
A. As mentioned above, one must trade up or even on price and use up all the cash. One can put more debt on the new property (if it costs more than the old property), but one cannot refinance in the middle of the trade and take cash off the table.
1031 exchange Question - How much gain do I have if I trade down?
A. The way to calculate this is first to figure out what the gain would have been on an outright sale. On a 1031 exchange, one can never have more gain than that. Then look to the amount of cash that was not rolled over, or the amount by which the purchase price of the new property is less than the selling of the old property. This will be the so-called "boot." The gain is the lesser of the gain that one would have had on an outright sale or the amount of boot. For example, say that on an outright sale one would have had $50,000 of gain. On the Exchange, there was $10,000 of cash that was not reinvested. The first $10,000 of gain is subject to tax. It is not one-fifth of the gain. The boot is taxed dollar for dollar off the top, subject to the limitation that there cannot be more 1031 Exchange gain than on an outright sale.
1031 exchange Question - Can a Partnership do a 1031 exchange?
A. One cannot exchange partnership interests, even if the partnerships own real estate. (Of course the partnership can do an exchange itself.) The same prohibition applies to interests in limited liability companies and corporations.
1031 exchange Question - What about 1031 exchanges with related parties?
A. One can sell old property to a related person and still do an exchange. One cannot purchase replacement 1031 property from a related person, even if the related person pays tax on the sale.
