Tamalpa Exchange Group provides brief answers to many commonly-asked questions about Section 1031 Exchanges. Tamalpa Exchange Group cannot guarantee its answers are necessarily the only correct ones. The Internal Revenue Code, final Treasury Regulations and case law remain silent as to certain areas of (tax) deferred exchange law. As a result, different interpretations of the law exist in some of these areas. The final regulations issued in 1992 provide guidance in previously uncertain areas, but also create new issues of concern. Nevertheless, Tamalpa Exchange Group believes that reading the following questions and answers will provide a valuable background concerning Section 1031 Exchanges.
INTERMEDIARY: Facilitator, middleman, strawman.
RELINQUISHED PROPERTY: Exchanger's property that is "sold"; old property; down-leg property.
REPLACEMENT PROPERTY: Property that Exchanger wishes to acquire; target property; new property; up-leg property.
EXCHANGER: Taxpayer; client who wishes to defer realized gain on "sale" of his or her property.
DELAYED EXCHANGE: When close of escrow on "sale" of relinquished property occurs before close of escrow on "purchase of replacement property; "Starker" exchange.
SIMULTANEOUS EXCHANGE: Escrows on relinquished and replacement properties close concurrently.
SALE AND REPURCHASE: The opposite of a deferred exchange; failed 1031 exchange.
REVERSE EXCHANGE: When replacement property is acquired by Intermediary before close of escrow on relinquished property.
LIKE-KIND: Properties that are exchanged which qualify for a deferred exchange.
BOOT: Replacement property that is not like-kind to relinquished property. Examples: Cash, promissory notes, personal property for real property.
CONSTRUCTIVE RECEIPT: Control of proceeds from sale of relinquished property by Exchanger without actual physical possession.
QUESTIONS AND ANSWERS
Q: I have a rental house for sale and my neighbor told me I could do a Starker exchange to avoid paying any tax on the sale. How does this Starker exchange work?
A: A Starker exchange is an informal name, based on a famous case, for a delayed (tax) deferred 1031 Exchange. A 1031 Exchange is a transaction where you trade your rental house for another like-kind property held for investment or for use in a trade or business. If your trade, or "exchange", qualifies under the rules found in Section 1031 of the Internal Revenue Code, any gain on the "sale" would be deferred.
Q: What is like-kind property?
A: With respect to real estate, practically all real estate is like-kind to each other. For instance, you could trade your investment house for a commercial rental or for vacant land held for investment.
Q: Can I also do this with my home when I sell it?
A: No. Your home is not investment property.
Q: Well, what if the replacement house was a residence for the seller?A: That's fine, as long as your intent when you acquired the replacement property was to use it for investment purposes.
Q: Is my potential tax wiped out by using a 1031 Exchange?
A: No, your taxable gain is deferred only. If you sell the replacement property, all deferred gain plus any gain earned on the replacement property will be recognized.
Q: What if I want to get some cash out of the transaction?
A: Any cash you receive will be treated as taxable "boot" or gain. Taking cash may even disqualify the entire exchange, depending upon when you receive it.
Q: When can I safely pull this cash out and not disqualify my exchange?
A: You must receive the cash no earlier than close of escrow on your replacement property. If you receive any cash at close of escrow on your relinquished property or during the "delay" period, you spoil the whole transaction and all of the potential gain is realized.
Q: Why don't I just refinance my property, take the cash out tax free, and then enter into an exchange?
A: You can't do this. The Treasury Regulations to Section 1031 say that if this refinancing is done in anticipation of an exchange, the amount refinanced will be treated as taxable "boot".
Q: Is there any way I can get some cash out of the transaction without paying tax?
A: Yes, if you first close escrow on the replacement property and then refinance that property. This cash would not be taxable.
Q: You have used the term "boot" twice. Give me a simple definition.
A: Boot is any sum of money (including net relief of liability) and the fair market value of any non-qualifying property received in exchange for your relinquished property. This boot is treated as taxable income to the extent there was gain realized on the conveyance of your relinquished property.
Q: That's not simple enough! Give me an example, please.
A: If you exchange your $300,000 duplex for a $200,000 rental house plus a $80,000 Mercedes and $20,000 cash, the car would not be like-kind property and therefore is "non-qualifying" property. Both the car and the cash are boot. If there was gain realized of $150,000 on the duplex, you would have $100,000 of taxable "boot" income. If gain realized was only $50,000, your taxable income would be $50,000.
Q: How much do I have to pay for my replacement property in order to totally avoid paying tax?
A: The value of the replacement property must be equal to or greater than the net sales price of your relinquished property.
Q: Why can't I just obtain a larger mortgage on the replacement property and not use all the cash proceeds?
A: Sorry, but you would break the rule of "equal equity," which is a twin to the above rule of "equal value."
Q: What's the rule of "equal equity"?
A: To totally defer taxable gain, the equity you wind up with in your replacement property must be equal to or greater than the net equity (after subtracting sales commissions and certain closing costs) of your relinquished property.
Q: Can't I do a simultaneous exchange? Wouldn't that be simpler than a delayed exchange?
A: Yes, a simultaneous exchange can be done. It used to be safer than a delayed exchange, but no longer, especially after the new regulations on delayed exchanges. The timing is hard to accomplish on a simultaneous exchange. And the big problem with the simultaneous exchange is that it is easy to blow the "exchange" requirement.
Q: Why?
A: For example, suppose your sale escrow closes at the same time as your purchase escrow with the proceeds from the sale escrow flowing directly into the purchase escrow and with you winding up owning the replacement property. In this scenario there has been no exchange! This would be simply a sale and repurchase and all gain is taxable.
Q: So what are the mechanics of a delayed exchange? Who holds my money during the period before I acquire the replacement property?
A: The regulations to Section 1031 have sanctioned several methods by which the sale proceeds can be held. TEG feels that using a Qualified Intermediary to hold the proceeds is the best method. The other methods require the buyer of your relinquished property to hold the proceeds in a qualified escrow or qualified trust, or to secure his or her promise to acquire the replacement property with some type of security interest or third-party guarantee. With these methods the buyer must be involved in purchasing the replacement property. Getting the buyer's cooperation is not easy or practical.
Q: Well, what makes an Intermediary "qualified"?
A: A Qualified Intermediary is a non-related party to the exchange transaction who, for a fee, acquires the relinquished property, sells this property to a third-party buyer, holds the sale proceeds out of the Exchanger's control, acquires the replacement property and finally conveys this property to the Exchanger. All of these acts are conducted pursuant to a written exchange agreement between the Exchanger and the Intermediary.
Q: Sounds complicated!
A: Not really. Properly done, this procedure will assure that a qualifying exchange takes place. A Qualified Intermediary, such as Tamalpa Exchange Group, will carefully monitor the entire process.
Q: You say the cash proceeds are out of my control during this period?
A: Absolutely. However, the regulations say that you will be entitled to the cash upon the occurrence of certain conditions. For instance, you will be entitled to the cash if you fail to identify a replacement property within 45 days of the first close of escrow or if you have acquired all of the replacement properties to which you are entitled.
Q: If keeping the cash out of my control is so important, why don't I just have my sale escrow company hold the money until I find a new property? Or have the cash proceeds transferred to my real estate broker's trust account?
A: Sorry, you would lose either way. Because the escrow company and the broker are your agents, you would have what the IRS calls "constructive receipt" of the cash. Your sale would be deemed completed and taxable gain, if any, would be recognized. Furthermore, you would fail to satisfy the exchange requirement.
Q: My neighbor mentioned 45-day and 180-day periods. What are these?
A: To qualify for a delayed deferred exchange, you have 45 calendar days in which to identify in writing to a neutral party the replacement property that you would like. Once you identify the replacement property or properties, you have an additional 135 days (or by the date of filing your next tax return, plus extensions, if earlier), in which to close escrow on the replacement property.
Q: Are these deadlines firm or am I allowed extra days for weekends and holidays?
A: Absolutely firm. No leeway is given by the IRS.
Q: How do I make this identification?
A: The regulations to Section 1031 allow you several ways. The most common method is to identify in writing three replacement properties. The writing is transmitted to a non-related party. You then have to acquire one of these identified properties.
Q What are the other ways?
A: You can identify four or more properties, but their total fair market value must not exceed 200% of the fair market value of your relinquished property. To totally defer taxable gain, you then have to acquire at least one of these properties and satisfy the twin rules of equal or greater value and equal or greater equity.
Q: What else?
A: If you blow both of these above rules, that is, you identify more than three properties with value greater than 200%, you will still qualify if you purchase 95% of the aggregate value of all of the properties identified. And one final rule states that if you purchase any replacement property within the 45-day identification period, that property will qualify for a Section 1031 exchange assuming all other criteria are met.
Q: What if I purchase a property within the 45-day period and also identify three other properties before the 45-day period?
A: The regulations are not specific on this point, but you probably fail the three property test and would have to rely on the 200% rule.
Q: Can my Uncle Joe act as the Intermediary on my Exchange?
A: No, because he is a "related" party. Most family members, as defined in the Internal Revenue Code, are deemed related parties and would not qualify under the regulations.
Q: How about my accountant acting as the Intermediary?
A: No, he would not qualify either. Professionals such as accountants or attorneys who act as your agents are considered related parties. You want somebody neutral and non-related.
Q: Since TEG is owned and managed by an attorney, how can it be a non-related party of the Exchanger?
A: The regulations say that an attorney is not the agent, and therefore is not a related party of the Exchanger, if that attorney only performs legal services sufficiently with to a Section 1031 exchange. Tamalpa Exchange Group will not act as an Intermediary when its owner, attorney George H. John, provides, or has provided, legal services to the Exchanger that are not sufficiently connected with a deferred exchange during a two-year period prior to the exchange. The regulations provide a safe harbor for non-related services prior to the beginning of this two year period.
Q: Congress has reduced the capital gains tax several times in several recent major tax acts, so I now would pay lower taxes on the sale of my rental house than before these tax acts. Should I still consider a 1031 Exchange?
A: Absolutely! Why pay taxes at all? Even with a capital gains tax reduction, the tax bite can be severe, especially if you've owned and depreciated the rental house for a long period of time.
Q: So, if I defer my gain each time I exchange into a new investment property, when do I finally pay taxes on this gain?
A: When you sell your last-held property. If you want, however, you can completely avoid recognition of this gain.
Q: How?
A: One of two ways. Dying is the simplest way, although in the average person's opinion, not the favored way. Whoever succeeds to the property will receive a new property income tax basis (bottom-line figure for computing gain) stepped-up to the fair market value of the property at the date of your death. In short, all deferred gain is wiped out! Converting one's investment property into a principal residence is possible, with the resident subsequently selling his residence and taking advantage of the large exemption from capital gains tax that is afforded a principal residence. Much care must be taken in documenting that you truly intended to convert the property into your principal residence. By the way, this step-up in income tax basis has been limited by the 2001 federal tax law, starting in year 2010 (and perhaps continuing for years thereafter), to an amount of $1,300,000 for each decedent, with an additional $3,000,000 of stepped-up basis allowed to property passing to a spouse.
Q: Can I carry back a note for part of the purchase price of my relinquished property?
A: The installment payments you receive on this note will be boot unless the note itself becomes part of the payment on the replacement property.
Q: Can I build some improvements on my replacement property and have the value of these improvements added to the value of my replacement property?
A: Yes, but only if you do not receive title to the replacement property until the improvements are completed. The Intermediary will be the party who contracts and pays for the improvements. Remember that you still have to be record owner within the 180-day time period, which means that all, or a substantial amount, of the improvements must be finished by this time.
Q: If I decide to do a 1031 Exchange, when do I contact Tamalpa Exchange Group or other Qualified Intermediary?
A: As soon as possible. If you have already entered into a purchase agreement with the buyer of your property, TEG will immediately arrange for the appropriate assignments and amendments. And feel free to call Tamalpa Exchange Group at (415) 479-5511 for any questions you may have about tax-deferred exchanges.