Keys to Exchanging
Keys to Exchanging
When dealing with the transfer of multiple properties, understanding the 1031 process and having access to a trusted exchange expert is the best strategy for a painless and successful exchange.
However, for those seeking a better understanding of the process, here are a few key “rules of the road” according to Internal Revenue Code Section 1031, and some select pitfalls that experienced exchangers always avoid.
THE PROPERTIES YOU EXPECT TO EXCHANGE MUST BE LIKE-KIND
“The Internal Revenue Service requires that the property you sell, as well as the property you buy, must be like-kind. And, like-kind means one of two things: Either (1) property held for investment or (2) property held for income. And definitely not your personal residence.”
YOU MUST UTILIZE THE SERVICES OF A QUALIFIED INTERMEDIARY
“The IRS requires that your exchange be completed with the assistance of a qualified intermediary or facilitator. This should be a well-established firm, like FYNTEX, so you know your exchange documentation will be correct, and your exchange funds will be safe between the time you buy and the time you sell.”
YOU HAVE A TOTAL OF 180 DAYS TO COMPLETE YOUR EXCHANGE
“You must complete your sale and purchase within a total of 180 days or whenever your tax return is due. The tax return qualifier means that if you start your exchange late in the year, you might have to file for an extension in order to receive your full 180 days.”
YOU MUST IDENTIFY CANDIDATE REPLACEMENT PROPERTIES WITHIN THE FIRST 45 DAYS
“Now, while you have a total of 180 days to complete your exchange, the IRS requires that you identify some candidate or target replacement properties within the first 45 days of your exchange period. Usually, this identification is made to your qualified intermediary by completing a form which is kept in your exchange file.”
THERE ARE DIFFERENT TYPES OF EXCHANGES, DEPENDING UPON YOUR CIRCUMSTANCES
“While a majority of tax-deferred exchanges are delayed or deferred exchanges, there are other types of exchanges which may better suit your situation. For instance, if your circumstances require that you must buy before you sell, you should consider a reverse exchange. Likewise, if your replacement property needs some improvement or full-on construction to meet your need, you can complete an improvement or construction exchange. And lastly, if your construction exchange must exceed the 180-day safe harbor timing requirement, you should inquire about a non-safe harbor exchange.”
THERE ARE SPECIFIC RULES FOR IDENTIFYING THE PROPERTY YOU EXPECT TO ACQUIRE
“The IRS requires the use of two rules or one exception for identifying potential replacement properties. The first is the three property rule, meaning you may identify up to three properties of any value. The second rule is the two hundred percent rule, meaning you may identify more than three properties provided all the properties you identify do not exceed 200% of the value of the property you sold. And the one exception is known as the ninety-five percent exception. Essentially, you may identify more than three properties and more than 200% of total identified property value, provided you acquire at least 95% of everything you identified.”
THERE ARE THREE THINGS YOU MUST DO TO HAVE A 100% TAX-DEFERRED EXCHANGE
“If you want a completely tax-deferred transaction, you must do these three things. First, buy replacement property which is equal or greater than the net selling price of what you sold. Two, move all your equity from the old property into the new property. And three, replace your debt.”
AVOID THESE TWO CRITICAL 1031 PITFALLS
“What are the two biggest 1031 pitfalls? Here they are. First, make sure your exchange funds are safe. The tax-deferred exchange industry is largely unregulated. This means that when your exchange proceeds are on deposit with your qualified intermediary (QI), your exchange funds actually belong to them. That is why you should always use an experienced and well-established QI. Second pitfall: Start looking for replacement property as soon as possible. Your 45-day identification period moves very quickly, so you may want to start looking for property even before your old property has closed.”
BUY REPLACEMENT PROPERTY IN THE SAME ENTITY AS WHICH YOU SOLD
“It is always better if you buy and vest your replacement property in the same name and entity as which you sold your relinquished property. To do otherwise – by changing entities in the middle of your exchange – could cause your exchange to fail for lack of meeting the held for investment or held for income requirement of IRC Section 1031.”
ARE YOU STILL WITHIN YOUR 45-DAY IDENTIFICATION PERIOD? YOU CAN REVOKE A PREVIOUS IDENTIFICATION AND RE-IDENTIFY NEW REPLACEMENT PROPERTY
“If you are still within your 45-day identification period, it is possible to revoke a previous identification and re-identify a new replacement property in your exchange. Simply complete your new identification and add revocation language at the top of your form.”
GETTING ACCESS TO TAX-FREE CASH CAN BE TRICKY
“If you need access to tax-free cash, borrow against your relinquished property well in advance of your 1031 exchange or borrow against your new replacement property after you’ve successfully acquired and closed it. This is possible because borrowing does not necessarily trigger a taxable event. However, if you attempt to borrow too closely to the start of your exchange, an argument could be created that your borrowing effort was a part of a stepped transaction and therefore not eligible for deferred gain treatment under IRC Section 1031.”
WHEN REPLACEMENT PROPERTIES ARE DIFFICULT TO IDENTIFY, YOU MAY WANT TO CONSIDER AN ALTERNATIVE REPLACEMENT PROPERTY SOLUTION SUCH AS A DST
“In active markets where it is difficult to locate and identify replacement property, it might be helpful to consider identifying an institutional Delaware Statutory Trust (DST) investment as your replacement property backup strategy. These are typically larger, professionally managed investment-grade portfolios which include individual property interests which are available to accredited investors through broker-dealers. If you have an interest in exploring what properties are available currently, contact us. We can give you the names of some broker-dealers who can answer your DST questions.”
To ensure compliance with requirements imposed by the IRS, we inform you that the information posted at this website does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice. Further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. If assisting with your Section 1031 tax-deferred exchange, Perch Wealth cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. We recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.
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- There’s no guarantee any strategy will be successful or achieve investment objectives;
- All real estate investments have the potential to lose value during the life of the investments;
- The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- All financed real estate investments have potential for foreclosure;
- These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments;
- If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits;
- Tax benefits are not guaranteed and are subject to changes in the tax code.