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How Can 1031 Exchange Help You In
Generating Business? The §1031 tax deferred treatment of
capital gains is one of the most attractive real estate
investor vehicles for preserving and building real estate
wealth: This provision of the tax code allows property
owners to exchange their property for other like-kind
property without recognition of capital gains.
The capital gain and tax liability are both transferred
(“deferred”) from the “old” property into the “new” one, so
there are not tax consequences or liability to the seller at
the time of the sale of the “old” property.
The beginning
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The concept of exchanging properties to avoid (“defer”)
tax is not new. 1031 exchange reformed variation of Two and
Multi-party exchange.
First; Two-party exchange
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Direct exchange (i.e., a swap), or the "your property"
for "my property" is called a
two-party exchange. Here there
are two property owners who each want the other's property.
When this rare situation occurs, the parties exchange
properties and avoid (“defer”) tax liabilities. The main
problem here is that rarely there will be two property
owners who each want the other's property.
Then; Multi-party exchange
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The three-way or multi-party exchange technique was
designed to solve the dilemma of a two-way swap. The big
problem here is that if one or more of the parties would not
cooperate with the exchange, the entire exchange failed like
a “Domino Effect”.
Now; 1031 Exchange
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By permitting you to "sell" your Relinquished (“old”)
Property now and use the proceeds to buy the Replacement
(“new”) Property later 1031 exchange eliminate the need of
finding another real estate owner who agrees to exchange
properties (instead of selling) to avoid tax liability.
Exchange Requirements
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Overview
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There are three conditions that must be met to accomplish
non-recognition of gain under §1031:
1. The properties exchanged must qualify, and be of
"like-kind".
2. There must be an actual exchange, not a transfer of
property for money only.
3. The time requirements must be strictly followed.
Qualify, "like-kind"
To qualify as a like-kind exchange, the property must be
both (1) qualifying property and (2) like-kind property.
What is a qualify property? For income tax purposes, real
estate is divided into four categories made as of the date
the transaction:
1. Held for business use (§1231) – property used in
normal course of business or rental property; Qualify
2. Held for investment (§1221) – property purchased and
sold for generating capital gain; Qualify
3. Held for personal use – vacation home, second home;
Does not Qualify
4. Held primarily for sale (dealer property) – resale or
inventory; Does not Qualify
The first two classifications “held for business” and
“held for investment” qualify for §1031 treatment while the
second two “held for personal use” and “dealer property-do
not”. What if a property falls under two categories?
For example what if a property held for investments
partially used for personal use? The sale will be allocated
between the two categories based on the portion of each one.
The Exchange Process
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The following is a review of the process and timeline:
Sale of Relinquished (“old”) Property
To trigger the tax deferred transaction, you must sell
your property.
Identification the Replacement (“new”) Property
You have 45 days from the day you sell the “old” property
to identify the replacement (“new”).
Replacement Property is identified only if it is
designated as one in a written document signed by you. This
document must be hand delivered, mailed, faxed or otherwise
sent before the end of the identification period to a person
(other than yourself or a related party) involved in the
exchange. The document must include unambiguous legal
description or street address of the property.
Number of Replacement Properties that can be identified
You may identify more than one property as Replacement
Property subject to three rules:
3-Property Rule: The maximum number of replacement
properties you may identify is three properties regardless
of their fair market values.
The 200 Percent Rule: There is no limit on the number of
properties you identify as long as their total fair market
value does not exceed 200 percent of the total fair market
value of all Relinquished Properties.
The 95 Percent Rule: There is no limit on the number of
properties you identify as long as during the Exchange
Period you actually received identified Replacement
Properties having a fair market value equal to or more than
95 percent of the total fair market value of all identified
Replacement Properties.
Value of Replacement (“New”) Property
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The value of the Replacement Property must be equal to,
or greater than, the adjusted sales price of the
Relinquished Property.
All proceeds from the Relinquished Property sale need to
be invested in the Replacement Property.
Sale Proceeds Go To Qualified Intermediary
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Section 1031 requires an actual exchange of properties.
If you simply sell your property and reinvest the money in
another property, you will not qualify for exchange
treatment, even though it is a simultaneous close.
A Qualified Intermediary is a person (or company) who,
for a fee, acts to facilitate the deferred exchange by
entering into an agreement with you for the exchange of
properties. The Qualified Intermediary does not provide
legal or specific tax advice to the exchanger, but will
usually perform the following services:
1. Coordinate with the exchangers and their advisors, to
structure a successful exchange.
2. Prepare the documentation for the Relinquished
Property and the Replacement Property.
3. Furnish escrow with instructions to effect the
exchange.
4. Secure the funds in an insured bank account until the
exchange is completed.
5. Provide documents to transfer Replacement Property to
the exchanger, and disburse exchange proceeds to escrow.
Receipt of Replacement Property
You have 180 days from the day you sell the “old”
property to receive the replacement (“new”).
Replacement property is treated as received before the
end of the exchange period if:
1. You actually acquired the Replacement Property (close
the transaction) prior to the end of the exchange period
(180 days, or the due date of the taxpayers tax return,
whichever is earlier), and
2. The Replacement Property acquired is substantially the
same as identified during the 45- day identification period.
Boot and Taxable Gain
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Money and unlike property in an exchange is called boot.
If, in addition to the Replacement Property, you receive
money or some other kind of boot, you may have taxable gain.
The tax is due only on gain that comes from the money and
other boot received.
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