Don’t misinterpret like-kind property
When completing a successful exchange, a taxpayer must relinquish and acquire like-kind property. However, many taxpayers misinterpret like-kind property. All too often I hear, “If I exchange a duplex, don’t I have to buy a duplex?” I always respond by clearly defining like-kind property.
Like-kind property refers to the intended use of the real property, not the type of real property, as investors often believe. Provided that the property is initially acquired and held for either business or investment purposes, it can qualify as a suitable replacement property under IRC Section 1031. Like-kind real property exchanges may, for example, include any of the following: bare land for a rental house, duplex for a fourplex, retail center for an apartment complex or an office building. And yes, you can also exchange from residential to commercial property (and vice-versa)!
Don’t overlook the key rules when structuring your exchange
Many taxpayers may attempt to complete an exchange by abiding by some, but not all of the basic structuring rules. To maximize tax deferral when completing a tax deferred exchange, it is pertinent that the taxpayer exchanges equal or up in both net value and net equity. Some taxpayers may attempt to simply reinvest their equity, but do not regard the equal or up requirement for value in the replacement property. The erred philosophy: “As long as I reinvest all of the proceeds I don’t pay taxes.” Although this argument may be true in some circumstances (some taxpayers have no debt on the relinquished property and no boot recognized in the transaction), this is a dangerous approach when structuring your exchange.
When completing any exchange transaction, the taxpayer should work closely with their tax professional to discuss their anticipated tax outcome and to structure the exchange. For example, some taxpayers will intentionally structure their exchange to defer some, but not all of their tax liability. A partially deferred exchange can help a taxpayer accomplish more than one of their goals, but is only going to please the taxpayer if the recognized gain is planned!
Don’t start looking for replacement properties late into the identification period
A taxpayer has 45 days from the date of the closing on the relinquished property to identify their replacement property. To identify, the taxpayer must sign a letter that provides an unambiguous description of the replacement property being acquired. As you may imagine, this strict timeline can be one of the most challenging aspects of performing an exchange. Unfortunately, once the 45 day identification period has passed a taxpayer is not able to switch their previously identified property for another. In addition, the taxpayer cannot add replacement property after the 45 day period!
A prominent real estate broker and exchange specialist sums up his strategy; “the best theory is to complete the exchange in the 45 day period. Once the 45 day identification period expires, the taxpayer looses their flexibility and is at the mercy of others!” So… start looking early in the exchange period. Consider hiring a broker who knows how to help you meet your exchange goals, and one who understands the significance of this crucial 45 day timeline! If you start looking late in the period, you may identify something other than what you really want or need!
Don’t control the exchange funds during the exchange period
I have been in the exchange industry since 2003, and have assisted taxpayers with the closing of thousands of exchange transactions. The role of the facilitator (aka: qualified intermediary, QI, exchange intermediary, accommodator) is to assist the taxpayer with exchange questions, to prepare the required exchange documents, and most importantly, to hold the exchange funds outside of the control of the taxpayer.
In a 1031 exchange the exchangor (the person exchanging) cannot have actual or constructive receipt of exchange funds. They cannot receive funds, borrow against funds or direct their use. During the exchange period the exchange proceeds remain in an exchange value account where they are outside of the exchangor’s control. Once funds are deposited into the exchange value account they remain there until the taxpayer acquires replacement property or terminates the exchange agreement. A taxpayer cannot ask for “draws” on the funds for personal use, and cannot hold them in an account that they control. In addition, the facilitator cannot be an agent or nominee of the exchangor.
Don’t decide to exchange after you sell
If a taxpayer would like to participate in a 1031 exchange transaction, they must set-up the exchange before the relinquished property is conveyed to the buyer. The exchangor must execute an exchange agreement with the exchange facilitator, and sale proceeds must be delivered to this facilitator and not the taxpayer.
If a taxpayer conveys title to a buyer, and then decides they’d like to exchange, it is simply too late to reverse this process! This is not an exchange, but is recognized as a sale transaction for the taxpayer. The lesson here is to plan ahead; for the taxpayer to determine if a sale or an exchange is the right fit for the transaction, before it closes.
Do not do an exchange if you are not holding for investment purposes
1031 exchanges allow a taxpayer to defer the recognition of gain on a relinquished property, provided that investment property is exchanged solely for like kind property that is held for the same use. Investment property is not property held for personal use, nor it is property that is acquired for resale purposes. As a result, the acquisition of a house for flipping purposes or for use as a second home would not qualify for exchange treatment.
Is it a second home or investment property? The Revenue Procedure 2008-16 provides a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. It states that a dwelling unit qualifies as relinquished/replacement property in an exchange if it is owned by the taxpayer for at least 24 months immediately before/after the exchange. In addition, during this period the taxpayer must rent the property at a fair rental for 14 days or more and the personal use of the property cannot exceed the greater of 14 days or 10% of the number of days during the year that the property is rented at a fair rental.
Written by: Sarah B. Johnson, Exchange CoordinatorCertified Exchange Specialist®
Vice-President, Cascade Exchange Services, Inc.
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