1031 Exchanges
The information on this page has been generously provided by Asset Preservation Incorporated, our nation's 1031 exchange authority. Visit apiexchange.com or call them toll-free at 1-800-282-1031 for more information.
What Is a 1031 Exchange?
Thanks to IRC §1031, a properly structured exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC §1031 (a)(1) states:
- "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
To understand the powerful protection an exchange offers, consider the following example:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
- As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the IRC. For instance, an accurate understanding of the key term "like-kind" - often mistakenly thought to mean the same exact types of property - can reveal possibilities that might have been dismissed or overlooked. API is your resource to obtain accurate and thorough information about the entire exchange process.
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Requirements for a Full Tax Deferral
A properly structured exchange is the transfer of property for property, thus deferring capital gain taxes. Any cash received, any reduction in mortgage or any other non-like-kind property received is considered "boot" and is taxable to the extent of the capital gain. To fully defer all capital gain taxes, an Exchanger must meet two requirements:
- (1) Reinvest All Exchange Proceeds
If an Exchanger does not reinvest all exchange proceeds from the sale of the relinquished property, the balance received is considered "cash boot," and gain may be recognized on that amount. - (2) Acquire Property with the Same or Greater Debt
If an Exchanger does not acquire a replacement property with an equal or greater amount of debt, he or she is relieved of a debt obligation, which is considered "mortgage boot." The IRS considers this reduction in debt a benefit to the Exchanger; therefore, it is taxable, unless it is offset by adding equivalent cash to the replacement property purchase.
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What Is Like-Kind Property?
Pursuant to IRC §1031, capital gain tax deferment requires the exchange of "like-kind" relinquished property for other "like-kind" replacement property. Contrary to the commonly held misconception that exchanged properties must be of the exact same type - for example, that bare land be exchanged for bare land or an income property be exchanged for another income property - the actual definition of "like-kind" is far more empowering in its flexibility:
- Any real property held for investment or real property used in a trade or business can be exchanged for any other real property held for investment or real property used in a trade or business.
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What Is the First Step?
1. Always discuss a §1031 tax deferred exchange with your tax and/or legal advisors.
2. Call API for a free consultation at any time and definitely before closing on the relinquished property. The following information is needed to begin preparing the exchange documents:
- The name, address and telephone number of the Exchanger; and
- The closer/escrow holder's name, address, telephone number and file number. We will prepare all necessary exchange documentation and will coordinate with the closer/escrow holder, the Exchanger's real estate agent/broker and his or her tax and/or legal advisors.
3. Include verbiage establishing the intent to affect a §1031 tax deferred exchange in the Purchase and Sale Agreement. The following are examples:
- SALE OF RELINQUISHED PROPERTY
"Buyer is aware that Seller intends to perform an IRC §1031 tax deferred exchange. Seller requests Buyer's cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, liabilities, costs, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to Asset Preservation, Inc. by the Seller." - PURCHASE OF REPLACEMENT PROPERTY
"Seller is aware that Buyer intends to perform an IRC §1031 tax deferred exchange. Buyer requests Seller's cooperation in such an exchange, and agrees to hold Seller harmless from any and all claims, liabilities, costs, or delays in time resulting from such an exchange. Seller agrees to an assignment of this contract to Asset Preservation, Inc. by the Buyer."
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Exchanger Checklist
(The below is also available as a downloadable PDF.)
REVIEW
Review the entire transaction with tax and/or legal advisors.
SALE CONTRACT
Enter into an "assignable” contract to sell the relinquished property. Execute the contract with the exchanger’s name and/or assigns.
CONTACT API
Before closing, contact API to initiate the exchange transaction: Call either our National Headquarters (800-282-1031) or Eastern Regional Office (866-394-1031), or go to apiexchange.com and click either on "Open a New §1031 Exchange" or "Exchange Information Sheet – Sale of Relinquished Property (Phase I)," which is a form you can fill out and submit.
EXCHANGE SET-UP
API will prepare the exchange documents for the relinquished property sale. The original documents will be forwarded to the closing officer who will coordinate the signatures. Copies of documents are forwarded to the exchanger.
RELINQUISHED PROPERTY CLOSES
API is assigned into the transaction as the seller and sale closes. Pursuant to the assignment agreement and exchange documents, API instructs the closing officer to directly deed the relinquished property to the buyer. Exchange proceeds are then transferred directly to API via wire transfer.
IDENTIFICATION PERIOD
Both the 45-day identification period and exchange period begin. Although it is the sole responsibility of the exchanger to meet all identification rules, API will forward confirmation of the exchange proceeds received, the time lines for the 45-day identification period and 180-day (or the date the tax return is due, whichever is earlier) exchange period, the identification requirements and the identification rules.
PROPERTY IDENTIFIED
Exchanger properly identifies replacement property by midnight of the 45th day. Specific written identification, signed by the taxpayer, is forwarded to API. Written identification can also be made to a party involved in the exchange transaction who is not a disqualified person. See the Treasury Regulations for more details on the identification requirements.
PURCHASE CONTRACT
Enter into an "assignable" contract to purchase replacement property. Execute contract with the exchanger’s name and/or assigns.
CONTACT API
After signing the replacement property contract, contact API: Call either our National Headquarters (800-282-1031) or Eastern Regional Office (866-394-1031), or go to apiexchange.com and click either on "Open a New §1031 Exchange" or "Exchange Information Sheet – Purchase of Replacement Property (Phase II)," which is a form you can fill out and submit.
EXCHANGE PAPERWORK DRAWN
API will prepare the exchange documents for purchase. The original documents will be forwarded to the closing officer who will coordinate the signatures. Copies of documents are forwarded to the exchanger.
REPLACEMENT PROPERTY CLOSES
API is assigned into the transaction and purchase closes. Pursuant to the assignment agreement and exchange documents, API instructs the closing officer to directly deed the replacement property from the seller. API wire transfers exchange proceeds to the closing officer.
COMPLETION
If all exchange funds are used to acquire the replacement property or properties, and all the exchange requirements are met, the exchange is complete.
