Why Should I Consider 1031 Exchanges?
A properly structured 1031 exchanges allows investors to sell income properties while deferring capital gains and federal and state income taxes. There are numerous rules of 1031 exchanges. But the result is that an investor can “exchange” the old property for a new, like-kind commercial property.
Who Can Qualify For 1031 Exchanges?
Individual investors, LLC companies, C corporations, S corporations, trusts, and partnerships may use 1031 to exchange one commercial property for another.
Can I Use My Lawyer To Complete 1031 Exchanges?
In order to carry out a 1031 exchange, you must use a qualified intermediary. According to the IRS, a qualified intermediary acts as an agent to the investor in all transactions. Although they need not be licensed, they cannot be agents of the investor. Or lawyers, real estate agents, or accountants – or anyone else who was hired for their services within the last two years. They also cannot be family members.
How Do I Choose An Intermediary?
It is essential you choose an intermediary that is both experienced and trustworthy.
Here is a list of questions to ask a potential intermediary.
- Are you a member of the FEXA (Federation of Exchange Accommodators)?
- Do you have fidelity bond coverage to insure against employee theft or embezzlement? What is the limit of coverage? Is it aggregate or per occurrence?
- Can you supply me with copies of your insurance binders and your agent’s phone number for verification purposes?
- What is the policy limit for errors and omissions coverage?
- How are 1031 exchange funds held? Are they held in qualified trust or escrow accounts to ensure creditors cannot attach them in case of bankruptcy?
- Do you undergo audits by an independent auditor?
- Do you have some system of checks or procedures in place in order to protect my funds?
- Are my exchange funds accessible within 24 hours?
- Do you have tax and exchange specialists available for me to consult with?
- Are funds stored separately in FDIC insured accounts?
- Do you strategically arrange closings to that I avoid boot and any related taxes (these can end up costing you more than the capital gains or income taxes)?
- Does the Intermediary deposit Exchange Funds in segregated and FDIC insured accounts?
Do I Have To Use All The Money From The Sale Of The Relinquished Property For The Exchange?
When completing a 1031 property exchange, all proceeds from the sale of the relinquished property must be used to purchase the replacement property. If you decide to hold back a portion of the proceeds for non-investment purposes, that money becomes what is called “boot.” In that case, those money becomes tax liable.
You must also make sure the debt service on the old property is the same as the one on the new property.
For example, let’s say the mortgage on the investment property that was sold for $1,700,000 was for $300,000. While, the new property, which costs $$2,000,000, has a mortgage of $300,000.
If you take the entire proceeds of the relinquished property and use it to purchase the replacement property, you will still have a debt service of $300,000. That is equal to the previous mortgage. Both debt services are equal, so there is no boot.
However, if the mortgage on the old property was $500,000 instead, then the new mortgage would be $200,000 less. The difference between the two ($300,000) would be what is termed mortgage boot and would be taxable.
What Is A “Like-Kind” Property?
Like-kind property refers to the type of property which can be exchanged for the property you are selling, which is called the relinquished property. The property you plan on purchasing with the proceeds of the sale from the relinquished property is called a replacement property. According to the IRS, it may only be used in the exchange if it is a like-kind property.
Contrary to popular belief, any type of commercial property may serve as like-kind property for another type of commercial property. So industrial property may serve as a replacement property for office property. The retail property may be exchanged for a warehouse, and a shopping mall may be exchanged for raw land.
Two exceptions apply to this rule. The first one is that foreign properties are not considered like-kind properties for relinquished properties located in the U.S. The second one is that an improvement made to raw land cannot be exchanged for raw land.
In addition, like-kind properties refer only to investment properties, not personal properties. Although, there are ways to use a property that was previously a primary residence and later converted to an income property in a 1031 exchange. You also cannot use a vacation home or a second residence as like-kind property.
Are There Any Time Limits On Completing 1031 Tax Exchanges?
There are two time limits that you must stick to if you are considering a 1031 exchanges.
First, you have 45 days to identify up to three other replacement properties. It is not enough to verbally state your choice. Your 1031 intermediary or the seller must have a written declaration signed and notarized by you. In the declaration, make sure to give a legal description of the property, which means the street address, or a distinguishable name.
Once you have identified at least one property, you have 180 days from the sale of the relinquished property to purchase one of your identified properties.
If you miss the 45 or 180-day time limit, you fail to identify a property, or you don’t purchase the property you have identified, then the exchange has failed. You will be liable for capital gains, federal, and state taxes on the full purchase price of the income property.
What If I Prefer To Buy A Property Other Than The One That Was Previously Identified?
The rules for 1031 exchanges is that as long as you are still within the 45-day time limit, you may do changes. You are allowed to revoke your previously chosen replacement property and identify in writing another one.
However, if the 45-day time period has already passed, then you may choose a different property as long as it is “substantially the same” as the one previously identified.
In this case “substantially the same” is very different than “like-kind.” For example, if you chose to buy several apartment buildings but in the end only chose two buildings, then they would be considered substantially the same. Or if you identified unimproved land, and later purchased only a portion of that land, then that would be acceptable.
The reason is that in both instances, what you received was not different in character or nature from the identified property. The IRS gives another example where an investor identified a barn with two acres of land. If later the investor purchased the barn without the land, then it would not be considered substantially the same because the basic character of the property has changed.
What If I Like To Buy More Than One Property?
Investors may identify (and purchase) more than one replacement property, using the 200% rule. According to this rule, if the market value of all the identified properties adds up to no more than 200% of the relinquished property, then any number of replacement properties can be identified and purchased.
Another rule that is used less often is called the 95% rule. In this case, the investor can only identify more than three properties with a combined value of not more than 200% of the price of the relinquished property if the investor acquires a minimum of 95% of the value of the identified properties.