There are different scenarios in which an exchange can work, for instance, a reverse exchange where an investor buys a property and then sells an existing property.
Typically, when a property held for investment or business purposes is sold for a greater value than the initial purchase price, any gain realized from the sale is subject to capital gains tax. These taxes can impact the total return and net proceeds of the sale. Through a Section 1031 exchange, the property owner/business can defer the capital gains tax by “exchanging” the sold property for a newly purchased property. This allows the property owner/business to reinvest the sale proceeds without having to pay additional taxes. If done correctly, a 1031 exchange can be a powerful way to save money.
The following outlines the basic steps of a 1031exchange (i.e., a delayed exchange) where an investor sellsa property first and then purchases another property.There are different scenarios in which an exchange can work, for instance, a reverse exchange where an investor buys a property and then sells an existing property.For the purposes of this article, we will focus on a delayed exchange. As with any tax strategy, it is advised that you consult with your attorney and tax specialist/accountant.
The exchange must be between like-kind properties. Generally, all real property is considered like-kind with all other real property. For example, you can exchange a sale of land for the acquisition of an apartment building, or vice versa. However, the real property purchased and sold must both be located in the United States.
It is important to make sure all properties qualify for a 1031 exchange. The properties involved in the exchange cannot be used for personal use; however, vacation homes can qualify if they are held as rental properties for a specific amount of time. Overall, the properties must be viewed as business or investment properties. Section 1031 does not apply to exchanges of:
Inventory or stock in trade
Stocks, bonds, or notes
Other securities or debt
Certificates of trust
The property identified for sale is commonly referred to as a “relinquished property.” Once the final sale price is negotiated, you and the buyer finalize the negotiations of a purchase and sale agreement. This is a document that outlines the terms of the transaction. In addition to price, other terms include buyer/seller representations, post-closing remedies for misrepresentations, damages if either party fails to close, emergency capital decisions pre-closing, and others. It is also very important to include a special clause in a purchase and sale agreement regarding your intent to conduct a 1031 exchange. The buyer must understand and be willing to cooperate with the seller to accomplish the seller’s 1031 exchange.
This is an important step because the IRS does not allow a 1031 exchange seller to simply sell a property and take the proceeds from the sale to acquire another property. The IRS requires that the sale of the relinquished property and purchase of the new property be completed as one transaction, and the seller cannot have direct control over the funds from the sale. The IRS requires a third party, called a Qualified Intermediary, to handle the funds throughout the process until the transaction is completed. The Qualified Intermediary is usually a title company, bank or law firm.
Once the Qualified Intermediary is identified, the seller will enter into an exchange agreement with the Qualified Intermediary, which grants the Qualified Intermediary the right to receive funds from the sale of the relinquished property. The agreement also provides direction to the Qualified Intermediary on how those funds are to be applied in the future. The Qualified Intermediary will hold the funds until the purchase of the replacement property, and then apply those funds to the new acquisition based on the terms of the exchange agreement.
Under the tax code, you must identify a replacement property/properties in writing and deliver the signed Identification of Replacement Property Notice to your Qualified Intermediary within 45 days of selling the relinquished property. You do not need to close the transaction in this 45-day window but simply identify assets you would like to purchase as your exchange property/properties.
There are several rules to consider when identifying new properties:
The new property or properties must have a fair market value equal to or greater than the relinquished property for you to get the full tax deferral.
You are able to identify up to three potential new properties, regardless of their value.
If you wish to acquire more than three new properties, you may do so as long as the identified properties do not exceed 200% of the sale price of the relinquished property.
If you identify more than three properties and exceed the 200% limitation, you must purchase 95% of the aggregate value of the identified properties.
Under the tax code, you have 180 days from the sale of the relinquished property to close the acquisition of the new property/properties. Although this may sound like a long time, real estate transactions can be time-intensive given the physical and legal due diligence required, as well as the financing process if acquired with a first-mortgage. Further, sellers may decide not to sell their property, which forces you to go to the next identified property on your list.
After negotiating the price and terms of the acquisition, you will direct the Qualified Intermediary, based on the terms of your exchange agreement, to enter into a purchase and sale agreement with the seller of the new property/properties. The Qualified Intermediary will fund the proceeds on your behalf to finalize the acquisition, and the deed of the property/properties will be assigned to you.
Similar to the purchase and sale agreement you entered into for the relinquished property, the purchase and sale agreement for the new property/properties must include special clauses related to the 1031 exchange.
After you complete the exchange, in order to receive the tax-deferment, you or your accountant must complete and file Form 8824 with the IRS in the tax year in which the exchange occurred. Also, there may be special state reporting requirements that must also be filed.
Form 8824 asks for:
Descriptions of the properties exchanged
Dates that properties were identified and transferred
Any relationship between the parties to the exchange
Value of the like-kind and other property received
Gain or loss on sale of other (non-like-kind) property given up
Cash received or paid; liabilities relieved or assumed
Adjusted basis of like-kind property given up; realized gain
This article is intended for informational purposes only, does not constitute investment, legal, tax, or accounting advice or any other advice of any kind, and may not be distributed in whole or in part without the prior written consent of Platform Ventures, LLC (“Platform Ventures”). This article does not constitute an offer to sell or a solicitation of an offer to buy any security and may not be relied upon in connection with the purchase or sale of any security. If any offer of securities is made, it shall be made pursuant to formal offering documents that would contain material information (including terms and conditions of an investment, risk factors, and tax information that are important to an investment decision) not contained in this article and that will supersede, amend and supplement this information in its entirety. Certain of the information contained herein has been obtained from published sources and/or prepared by third parties. While such sources are believed to be reliable, Platform Ventures or its respective affiliates, employees, or representatives have not independently verified and do not assume any responsibility for the accuracy of such information. Investments in real estate, including 1031 exchanges, involve risks. Risks include, but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk.
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