Q - Can I do a 1031 exchange after my sale property has closed?
A - No. In order to qualify for a tax deferred 1031 exchange the investor (seller) is required to engage the services of a Qualified Intermediary and execute an exchange agreement prior to the sale of the relinquished property. Best practice is to contact the QI and have all required documents signed and completed well before the close of escrow to ensure everything is in order for the exchange to become official. Any properties that were sold prior to entering into an exchange agreement with a QI will automatically disqualify a seller from participating in a 1031 exchange.
Q - I would like to take advantage of a tax deferred exchange but I need $40,000 for my daughters college tuition this year. Can I get some cash and just do a partial exchange?
A - Yes. You may do a partial deferral and reserve a portion of the sale proceeds to come back to you as “taxable boot”. The escrow or settlement agent handling the closing of the sale would be notified of your request to reserve $40,000 and the remaining balance of the proceeds would go into the exchange.
Q - Can I sell my single family rental home and purchase a multi-unit apartment building?
A - Yes. You can exchange into any type of real property within the United States as long as it is business or investment real estate. Like-kind covers a broad spectrum of property types including Residential, Commercial, Multi-Unit Dwelling, Land, Industrial, DST, Retail, 30-Year Leasehold, etc.
Q - I hold title to my sale property in a Revocable Trust wherein my wife and I are both trustees. We would require lender financing on the replacement property but the loan approval is contingent on taking title in our personal names. Is this allowed?
A - Yes. This is permissible because the IRS same taxpayer requirement is maintained. If the trust has been treated as a disregarded entity for federal tax purposes and filing taxes under your social security number, then you may purchase under your individual husband and wife names. While the legal entity has changed from sale to purchase, the taxpayer has not.
Q - My business partner and I hold title to a property in an LLC Partnership where we file taxes using the entities FEIN number. I would like to exchange, but my partner wants to cash out his interest. I would ultimately be acquiring the purchase property as just a sole individual. Is this possible?
A - No. IRC Section 1031 requires the taxpayer remain the same from the sale to the purchase in an exchange. If the LLC Partnership has been filing taxes under its federal ID number and upon the sale closing one of the members cashes out on his interest and the partnership dissolves, this would directly affect the taxpayer requirement and disqualify the remaining individual from moving forward with the exchange. Solutions include changing title well before the exchange, structuring a “drop and swap” or “swap and drop.” In these cases it is best to consult your CPA or Tax Advisor before the sale approaches to resolve vesting that could complicate your exchange.
Q - I am a first time exchanger and I have a property that my wife and I originally purchased for $500k which we have been renting out the past 5 years. We plan on listing it soon and believe it will sell for around $650k. We would like to do a 1031 exchange where the replacement property we are looking to purchase is valued at $500k. Our goal is to do a 100% tax deferral as we want to avoid the capital gains tax. Will this work?
A - Unfortunately, No. For a 100% tax deferral you will need to replace the value of your relinquished property. The IRS requires you to purchase property that is equal or greater in value to your sale in order to qualify for a complete tax deferral. Since the property you are planning to purchase is significantly lower than your sale value, you will be subject to capital gains tax on the difference between the two values. However, the IRS will allow you to factor in three allowable costs: 1) Realtor Fees 2) Title and Escrow Fees and 3) Exchange Fees. Your sale price minus these three costs will bring you to your net sales value which you will need to achieve as your new purchase marker to defer all your capital gains tax on the sale.
Q - A week ago I completed and submitted my identification form which included 3 potential replacement properties. Since then I have reassessed the properties and am no longer interested in purchasing any of them. Am I allowed to re-identify new properties?
A - If you are still within your 45 day period, then yes. The IRS rules state that the exchanger may revoke and replace their replacement property identification form if they have not exceeded the 45 day period. Best practice is for the exchanger to notify their Qualified Intermediary in writing that they would like to revoke their identification and replace it with a new one which would include the new properties. Keep in mind that an identification can not be changed or revoked after the 45 day period. Once the exchanger passes this deadline, they are required to purchase what they have identified or they will fail their exchange. Unfortunately their is no exception to this rule and it must be strictly followed.
Q - My 45 day deadline falls on a Sunday. Does that mean I can turn in my identification the next business day (Monday)?
A - No. The 45 day deadline is a strict requirement, and the IRS makes no exception for holidays or non-business days. The 45 day deadline is measured according to calendar days and begins the day after the transfer (i.e. closing) of your first relinquished property. A timely identification will be made if turned in before midnight (12 am) of the 45th day. In this case, if your deadline falls on a Sunday, you must turn in your identification by 11:59 pm on Saturday. In similar circumstances, when a deadline falls on a weekend, it is best to turn in your identification to your Qualified Intermediary the preceding business days to ensure receipt and valid identification.
Q - Can the 45 day identification deadline be extended?
A - No. The only case where the deadline could be extended is if there is a federally declared disaster. The IRS provides no alternative solutions or exceptions to the 45 day identification deadline. It must be strictly adhered to and not underestimated as it could make or break the deal. To avoid the major time restrictions, it best that an exchanger make efforts early on to locate potential replacement property and complete their identification before the deadline date nears.
Q - My husband and I would like to do an exchange but we are curious about how the rules work regarding getting our money back if for some reason we aren’t able to complete the exchange?
A - Section 1.1031 of the Treasury Regulations provides for the Safe Harbor guidelines pertaining to exchangers limitations to funds during the exchange period. Specifically, 1.1031(k)-1(g)(6), often referred to as the g6 regulations, within the Treasury Regulations sets forth the restrictions that must be strictly adhered to. The Regulations state that once the exchange funds are received from the sale property by the Qualified Intermediary, the exchanger has limited rights and cannot “receive, pledge, borrow or otherwise obtain the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period.” Funds may be returned to the exchanger only in the following circumstances: 1) After the end of the 45 day identification period if the investor has failed to identify replacement property; 2) After the investor has received all the identified replacement properties to which the investor is entitled; 3) At the end of the 180 day exchange period; or 4) If the investor identifies replacement property before the end of the identification period and the occurrence of a material and substantial contingency that: (a) relates to the deferred exchange; (b) is provided for, in writing, and (c) is beyond the control of the investor and of any disqualified person, other than the person obligated to transfer the replacement property to investor.
Q - Is there a way to avoid taxable boot when doing an exchange?
A - Yes. To avoid taxable boot or any taxation on the sale of the relinquished property the exchanger would need to complete a fully tax deferred exchange. To accomplish this the exchanger must purchase replacement property that is equal or greater in value than their sale and reinvest all the net sale proceeds into the replacement property. Taxable boot occurs when the exchanger does not fulfill the value and debt replacement requirements, receives proceeds from the relinquished property, or has left over funds in the exchange.
Q - Can I use exchange funds to pay for my loan fees on my replacement property?
A - This is not recommended and most QI’s will advise against it. The IRS views the costs of obtaining a loan to be separate from the costs of directly acquiring real estate. Certain costs such as mortgage insurance, loan fees, points and even loan appraisal fees will generally cause taxable boot for the exchanger because they are viewed as expenditures for benefits other than acquiring the replacement property. In addition, using exchange proceeds for expenses unrelated to the direct purchase or sale of exchange properties can create further issues such as constructive receipt of exchange funds which is in violation of the Treasury Regulations causing the exchange to fail. In a case like this, exchangers will use their own personal funds to pay for any fees or costs associated with acquiring a loan.
Q - I own a 4-plex where I live in one of the units and rent out the other three. Will I still qualify for the 1031 exchange?
A - Yes. The IRS allows the 1031 tax deferral to be applied to the portion of the property that was held for investment. In this case the three units being rented out to the tenants would qualify. Before the sale occurs the exchanger would need to consult their tax adviser to have the percentage allocated for what part of the property is investment and primary use. The investment portion may be exchanged while the primary use portion could qualify for the IRC 121 exclusion if the taxpayer owned and lived in the property for at least two of the last five years leading up to the sale. If the exchanger does not qualify for the 121 exclusion then the primary use portion would come back to them as taxable income.
COMBINING A 121 EXCLUSION WITH A 1031 EXCHANGE
Q - Can I exchange the home I have been living in?
A - It depends. Section 1031 of the tax code applies to properties held for investment (rental) or trade/business use for 2 years prior to the exchange, or at least one tax filing season. Section 121 of the tax code applies to primary residences wherein the taxpayer has lived in the home for 24 total months out of the last five years. An exchanger may qualify under both sections of the tax code. If an exchanger has lived in the property for at least 24 months of the last five years, he or she will fall under the 121 exclusion which exempts a tax break on $250,000 for an individual and $500,000 for a married couple. Exchangers may combine a 1031 exchange with the 121 exclusion if, for example, the same property that was owned and lived in for a total of 24 months was then converted into an investment or trade/business use property 2 years prior to the exchange. In combining the 121 and 1031, preceding the sale, the property must have been held for investment for two years, and preceding this holding the taxpayer must have used the property as a primary residence for two of the last five years. Exchangers are encouraged to seek guidance from their tax advisor in structuring these exchanges as there are different conditions that apply to each exchangers context and filing requirements to successfully receive exchange and exclusion treatment.
MOVING INTO THE REPLACEMENT PROPERTY
Q - Am I able to move into the property after my exchange is complete?
A - There are certain provisions the IRS has regarding the time period an exchanger must hold the property for use in a business, trade or as a rental. In this case, following a successful 1031 exchange, the taxpayer must maintain their intent of the property being held as an investment to avoid being audited by IRS or disqualifying the exchange. In order to safe harbor the exchange, the taxpayer should intend to hold the replacement property for at least 2 years before converting it to a primary residence. However, before doing so the taxpayer should discuss any type of conversion with their tax adviser to better understand any applicable tax implications.
Washington state law, RCW 19.310.040, requires an exchange facilitator to either maintain a fidelity bond in an amount of not less than one million dollars that protects clients against losses caused by criminal acts of the exchange facilitator, or to hold all client funds in a qualified escrow account or qualified trust that requires your consent for withdrawals. All exchange funds must be deposited in a separately identified account using your taxpayer identification number. You must receive written notification of how your exchange funds have been deposited. Your exchange facilitator is required to provide you with written directions of how to independently verify the deposit of the exchange funds. Exchange facilitation services are not regulated by any agency of the state of Washington or of the United States government. It is your responsibility to determine that your exchange funds will be held in a safe manner.