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1031 EXCHANGE FAQ:
WHAT
IS A 1031 TAX EXCHANGE?
Section 1031 of the tax code allows a
taxpayer to defer the recognition of a gain or loss on the
exchange of Like-Kind Property, and thus postpone the payment of
tax. In order for a transaction to qualify for a
1031 Tax
Exchange it must take the form of an “exchange” rather than a purchase and sale,
the property disposed of and the property received must both be held for investment purposes, or
for the productive use in a trade or a business, and the property disposed of and the property received must be of like-kind in nature.
WHO SHOULD
CONSIDER A 1031 EXCHANGE?
If you are thinking about selling your
business or an investment property you should consider a 1031
tax exchange. A 1031 tax exchange will enable you to reinvest
the Federal capital gains that you would normally have to pay in
taxes to the IRS. A
1031 Property Exchange will enable you to keep
this money and reinvest it in another like-kind asset.
Essentially, a 1031 Exchange can be thought of as an
interest-free loan from the IRS; one in which the principal may
be increased through subsequent exchanges and may never require
repayment, if you plan properly.
WHAT IS A BUILD
TO SUIT 1031 EXCHANGE?
A Build to Suit 1031 Exchange, also known
as a Construction 1031 Exchange, allows a taxpayer to use all or
part of the 1031 exchange funds to build their replacement
property. In essence, a property owner can sell their old
property, defer the payment of taxes, and then use the proceeds
to construct a new replacement property.
IS THERE A LIMIT TO HOW MANY 1031 EXCHANGE TRANSACTIONS I CAN
COMPLETE?
The current IRS Section 1031 rules enable
investors to exchange properties time and again. This ability
allows them to use all of their equity to increase their
portfolio net worth at a much faster pace than if they were to
sell their properties, pay taxes to the government, and then
acquire another property with their remaining equity.
CAN I 1031
EXCHANGE MY PARTNERSHIP INTEREST?
Section 1031 of the tax code specifically
prohibits the exchange of interests in partnerships. For
example, an interest in ABC partnership cannot be exchanged for
an interest in XYZ partnership. However, if ABC partnership owns
real property, they can 1031 Exchange their real property with
any other entity as long as they meet the 1031 Exchange
requirements.
WHY SHOULD I DO A 1031 TAX EXCHANGE INSTEAD OF JUST SELLING MY
PROPERTY?
The most important reason is to defer paying
taxes to the government on any gain that you may realize from
the sale of the property. By participating in a 1031 tax
exchange you may be able to use all of your equity to
acquire another property, instead of just the amount of equity
left over after paying taxes to the government.
CAN I TAKE
CASH OUT OF A 1031 EXCHANGE?
You cant take cash out or receive cash in a
1031 Tax Exchange without creating a taxable event. If an
investor in a 1031 Tax Exchange elects to take some of the
equity out of the sale proceeds in the way of cash or a note,
this is called BOOT and is taxable (you will be subject to
paying taxes on the amount of cash or boot received). However,
to avoid taxable boot and take cash out, an investor in a 1031
Tax Exchange can refinance the property after the 1031 Tax
Exchange transaction is completed.
WHAT ARE 1031 TIC
EXCHANGES?
A 1031 Tic Exchange, or a
1031 Tenants in
Common exchange, allows an investor to exchange
their property for a fractional share in another property.
Instead of exchanging your property with another property of
similar size, an investor can exchange their property for a
fractional share of a large institutional grade real estate
asset. 1031 Tic Sponsors are
companies that specialize in arranging these transactions. For
an investor, these transactions offer every advantage that a
traditional 1031 Tax Exchange offers and more. They are large in
size and can easily withstand fluctuations in the economy or
market, they are typically managed by a professional property
management company, and they typically come already packaged up
with financing and insurance. For an investor, these
transactions take almost all of the work out of owning rental
property.
WHAT
IS LIKE-KIND PROPERTY?
Like-Kind Property is a general term that is
meant to be interpreted very broadly. It refers to the nature of the property or its use, and not to its quality. There are 3 guidelines that help taxpayers distinguish between what is
Like-Kind Property
for 1031 Exchange purposes and what is not. Livestock of different sexes are specifically not
Like-Kind Property
for 1031 Tax Exchanges, Real Estate can only be
1031 Exchanged for other Real Estate and Personalty can only be
1031 Exchanged for other personalty.
WHEN SHOULD I NOTIFY RELATED PARTIES ABOUT MY INTENT TO COMPLETE
A 1031 TAX EXCHANGE?
The IRS requires you to notify related
parties in writing about your intent to complete a 1031 tax
exchange. You must tell the buyer of the property that you are
selling and the seller of the property that you are exchanging
with of your intent to complete a 1031 Tax Exchange. You
should, however, wait until all terms of the Purchase Contract
have been agreed upon before making this notification.
CAN I CLOSE SALE ON MY NEW PROPERTY BEFORE I HAVE A BUYER FOR MY
CURRENT PROPERTY IN A 1031 EXCHANGE?
Yes. This is known as a Reverse 1031 Tax
Exchange. The IRS has adopted regulations specifically to allow
Reverse 1031 Tax Exchanges. The
Reverse 1031 Tax Exchange
receives basically the same tax benefits as a regular 1031 Tax
Exchange. To make the Reverse 1031 Tax Exchange work, someone
other that yourself (usually your Qualified Intermediary) must
take title to one of the properties until you are ready to
convey your old property to a buyer.
WHAT IS A REVERSE 1031 EXCHANGE?
A Reverse 1031 Exchange is when the exchanger
closes on their new replacement property before they have sold
their old property. The IRS has adopted regulations
specifically to allow Reverse 1031 Tax Exchanges. The Reverse
1031 Tax Exchange receives basically the same tax benefits as a
regular 1031 Tax Exchange. To make the Reverse 1031 Tax Exchange
work, someone other that yourself (usually your Qualified
Intermediary) must take title to one of the properties until you
are ready to convey your old property to a buyer.
WHAT
IS A SAFE HARBOR REVERSE 1031 TAX EXCHANGE?
A Safe Harbor Reverse 1031Tax Exchange
involves the accommodator temporarily holding the new property
for the exchanger until the old property is sold. Within 45 days
of this arrangement, the exchanger must identify this new
property as being the replacement 1031 Tax Exchange property.
The exchanger also has 180 days to complete the 1031 Tax
Exchange transaction in order for it to be regarded as
Safe
Harbor. This safe harbor method of structuring a Reverse 1031
Tax Exchange is outlined in the 2000 IRS guidelines. This is
viewed as the safest way to structure a Reverse 1031 Tax
Exchange because it is clear that the exchanger does not receive
any property prior to completing the transaction.
WHAT IS A TRADITIONAL REVERSE 1031 TAX EXCHANGE?
A Traditional Reverse 1031 Tax Exchange is
structured the same way as a safe harbor Reverse 1031 Tax
Exchange except that the exchanger cannot meet the 180 day time
requirement. This is usually due to the exchanger having
difficulty selling their old property. When this is the case,
make sure that your tax advisor takes the proper precautionary
measures to document and insure the integrity of your Reverse
1031 Tax Exchange.
WHAT
IS A CONSTRUCTION REVERSE 1031 TAX EXCHANGE?
A Construction Reverse 1031 Tax Exchange
allows a taxpayer to acquire a piece of raw land for future
development before selling their old property in a 1031 Tax
Exchange. Construction Reverse 1031 Tax Exchanges are structured
in the same way as traditional and Safe Harbor Reverse 1031 Tax
Exchanges. In a Construction Reverse 1031 Tax Exchange the
accommodator temporarily holds the land for the exchanger until
the old property is sold. Once the old property is disposed of
the exchanger can begin to build on the new land.
WHAT IS A 1031 STARKER EXCHANGE?
A 1031 Starker Exchange is just another
word for a Reverse 1031 Tax Exchange. A
1031 Starker Exchange
allows an owner of investment property to postpone the payment
of capital gains taxes and depreciation recapture taxes on the
sale of their property. They are allowed to defer these tax
payments only if they reinvest the proceeds from the sale into
another like kind property.
A Starker Exchange is a 1031 tax exchange
in which the taxpayer purchases their replacement property
before they sell their old property. This is the most commonly
used type of 1031 Tax Exchange and is specifically allowed by
the IRS through a statutory amendment (Tax Reform Act of 1984).
These exchanges are known as "Starker" exchanges because of the
name of the litigant in the case that determined the law.
HOW DO I
REPORT A 1031 EXCHANGE TO THE IRS?
Initially, 1031 Tax Exchanges get reported on
the IRS on form 1099S. This tells the government that you are
facilitating a 1031 Tax Exchange and will receive like kind
replacement property as consideration for the sale of your old
property. Then, IRS Form 8824 must be completed and included as
part of your annual Federal tax return. This form will
determine your realized gain, your recognized gain, and your
basis in new property received. This form will also ask the date
in which you sold your old property and the dates you identified
and acquired your like kind replacement property.
DO MY CHANCES OF BEING AUDITED INCREASE AS A RESULT OF A 1031
TAX EXCHANGE?
The IRS currently audits approximately 1% of
all tax returns. A 1031 Tax Exchange is not likely to increase
your chances of being audited.
WHAT HAPPENS TO THE SALES PROCEEDS OF MY OLD PROPERTY IN A 1031
EXCHANGE?
To totally defer the payment of tax, it is
essential that the Exchanger (who is both the owner and seller
of the property) does NOT receive any money in the 1031 Tax
Exchange Transaction. When you sell your old property, the
funds that you would normally receive should be wired to the
Qualified Intermediary and placed into a separate holding
account until you purchase your new replacement property. Each
1031 Tax Exchange transaction has its own account.
At the closing of the new replacement
property, the funds required to close the transaction are wired
to the seller from the 1031 Tax Exchange account held by the
Intermediary.
WHAT IS A QUALIFIED
INTERMEDIARY?
A Qualified Intermediary is an entity that
helps structure, consult, guide and document a 1031 Tax Exchange
transaction. An experienced
Qualified Intermediary will provide
safety and security for the investors funds and provide
technical experience in maintaining the integrity of the 1031
Tax Exchange. Qualified Intermediaries are not allowed to give
tax or legal advise, and should not replace professional tax or
legal opinions.
WHAT IS A CERTIFIED EXCHANGE
SPECIALIST (CES)?
The
Certified Exchange Specialist is a
professional designation given to individuals who possess
certain work experience and have passed certain exams related to
the 1031 Tax Exchange. The certification was created to provide
consumer confidence to property owners who seek professional
assistance with 1031 Tax Exchanges. The certification
demonstrates that the professional possesses a certain level of
experience and knowledge within the realm of the 1031 Tax
Exchange.
WHAT IS A SALE LEASEBACK 1031
EXCHANGE?
A Sale Leaseback is when the owner of a
property sells the property and then leases it back from the new
owner. Business owners often do this to unlock “trapped” equity
in their mortgages due to amortization, or to realize the gain
in appreciation of property values. By doing this, business
owners are able to realize this equity and use it to expand
their business operations. The beauty of a sale-leaseback
transaction is that the business owner doesn’t have to move
their operations, and the new lease payments are tax deductible
expenses in the year that they are paid. In the case of a
Sale-Leaseback 1031 Exchange, the investment property owner will
sell their business property and use the sales proceeds to
purchase another replacement property, while taking into
consideration all the necessary precautions and regulations of a
1031 Tax Exchange. This will enable the business owner to
maintain leasing the space that occupies their business while
unlocking their accrued equity and diversifying their income by
reinvesting it in another piece of commercial real estate. The
business owner will now pay rent on their space instead of a
mortgage payment, but will now receive rental income from their
newly acquired investment property.
What is a 721 Exchange?
Like a 1031 Exchange, a 721
Exchange is an effective vehicle for deferring capital gains
taxes. A 1031 Exchange allows an investor to sell their
investment property and reinvest in another like kind property
while deferring capital gains taxes. Under a 721 Exchange, an
investor can sell their property to a partnership in exchange
for shares or ownership in that partnership and defer paying
capital gains taxes.
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