1031 tax-deferred exchanges were established as part of United States tax law in 1921, yet there are still misconceptions about like-kind exchanges and how they work. Let's clear up a few in this post.
I can receive tax deferral by rolling over my gain into new property
No, this is not the case. In order to receive full deferral, the value of the property must be replaced, net of the closing costs. In other words, the net proceeds from the sale of the relinquished property must be rolled over and new debt must be on the new property in an amount equal or greater than the amount of debt paid off in the sale of the relinquished property. The first dollars not rolled over will be considered return of the gain, not return of the capital investment nor prorated between the gain and capital investment.
If I trade up or even in value, I am deferring all my gain.
Yes and no. More specifically, a taxpayer has to use up all the net cash and have equal or greater debt than was paid off upon sale of the relinquished property. And while excess cash can be added to replacement property to replace debt retired, the corollary is not true; excess debt on replacement property will not offset cash received upon the sale of the relinquished property.
If I or my attorney holds the buyer’s earnest money, my exchange will fail due to the receipt of funds.
While it is true that actual receipt, in which you hold the buyer’s earnest money, or constructive receipt, in which your attorney or agent holds the buyer’s earnest money, will violate the rule that a taxpayer can have no right to “receive, pledge or otherwise obtain the benefits of money,” technically these rules do not come into being until the time of the exchange event, i.e. the sale of the relinquished property. As such, holding the funds prior to that time is not a problem so long as the funds are turned over to the qualified intermediary directly or through the settlement agent at the time of closing.
If I elect to terminate the exchange and pay full taxes owed, I can receive my exchange funds at any time.
The exchange regulations appear to be contrary to this common sense position. The regulations allow return of funds only upon the failure to identify replacement property within 45 days of the sale of relinquished property or upon taxpayer’s receipt of all identified property which the taxpayer is entitled to acquire or upon the expiration of the 180 day exchange period. In the year 2000, the IRS issued a Private Letter Ruling underscoring these rules (https://www.accruit.com/blog/early-release-exchange-funds-possible-under-1031-exchange-rules) Even if a taxpayer is not concerned about a violation of these rules in the event of a failed exchange, the qualified intermediary abides by the rules in order to establish a course of conduct consistent with the rules.
I cannot effectuate an exchange if my contract fails to contain an Exchange Cooperation Clause.
Not so. Early in the history of exchanges, a buyer had to actively participate in the exchange in order for the taxpayer to be able to complete an exchange. Modern day rules only require that the buyer of the old property and the seller of the new property receive written notice that the taxpayer has assigned the rights (but not the liabilities or obligations) to the qualified intermediary. No signature nor other affirmative action is required by the other parties. So unless the property is in one of the few states, like New York, where assignments are not permitted without a provision in the contract, they are otherwise freely assignable.
So long as written notice of the assignment of rights is given to the buyer of the relinquished property and the seller of the replacement property, I have conformed to the requirements under the regulations.
In most cases this is true. However the regulations state that all parties to the contract must be given written notice of the assignment. So in the case of multiple sellers or multiple buyers on the taxpayer’s side of a transaction, all co-sellers or co-buyers must also receive written notice for compliance. In one recent instance being handled by our office, the escrow agent was named as a party to the contract and the client’s attorney was instructed to ensure that the agent also received written notice of the assignment.
Identification of replacement property has to be made to the qualified intermediary.
Although it is most common to make the 45-day identification to the qualified intermediary, the regulations actually allow the identification to be made to the seller or “any other person involved in the exchange other than the taxpayer or a disqualified person.” Examples provided in the regulations include the buyer of the relinquished property, the intermediary, the title company and the escrow agent. So a valid indication can be made to these parties and not necessarily to the intermediary. For example, a provision in the replacement property contract could indicate that the buyer is identifying the property as his replacement property for his exchange.
A taxpayer can direct the qualified intermediary to pay legal or accounting fees from the exchange account.
Perhaps. Certain transactional costs can come from the exchange account however the expense must (i) pertain only to the exchange transaction and (ii) would be an expense that would “appear under local standards in the typical closing statement as the responsibility of a buyer or seller.” Attorney’s fees may typically appear on a closing statement in certain locales, but one would not expect to see accountant’s fees on a closing statement. Payment for transactional costs should be done with care and only if they fall within the above two prong test. Examples appearing in the regulations include real estate commissions, prorate taxes, recording or transfer taxes and title company fees.
A taxpayer can pay loan-related costs for the replacement property from the exchange account.
No. Not every cost associated with the acquisition of replacement property can be paid out of exchange funds. Remember, these are like-kind exchanges. Real estate is exchanged for real estate, not for loan costs. So such items as loan commitment fees, points, appraisal and credit reports should be paid from separate funds.
A limited liability company member or a partner in a partnership can do their own exchange upon sale of property owned by the LLC or partnership.
This is the most common question or misconception seen by qualified intermediaries. Unfortunately, the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code Internal Revenue Code does not allow an individual member or partner to do an exchange; it can only be done at the entity level. In order to get around this restriction, it was somewhat common to cause the LLC or partnership to deed a fractional interest in the property to the individual immediately before the sale so that she would not be selling in her capacity of a member or partner. The interest was “dropped” to her so she could “swap” it as part of an exchange. These are known as Drop & Swap techniques (https://www.accruit.com/blog/1031-drop-and-swap-out-partnership-or-llc). Because a proper exchange requires a period of “holding” the property before the sale, this technique is frowned upon by the IRS unless the “drop” takes place well in advance of the sale and ideally in advance of the property going under contract.
If multiple properties are being sold by one seller under one contract, they are considered one property for the purpose of the three-property rule
Probably not. If there are contiguous lots and multiple permanent index numbers, an argument can be made that they cannot be sold separately and therefor only constitute one property. However if they are not contiguous and/or are capable of being sold separately (despite the seller’s preference not to) they are likely considered separate properties for purpose of this rule (https://www.accruit.com/blog/what-are-rules-identification-and-receipt-replacement-property-irc-%C2%A71031-tax-deferred-exchange). (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s commonly identify Delaware Statutory Trust (DST) investments. A single investment might be comprised of a fractional share in a portfolio of properties. This is an example of each property being considered a separate property for purposes of the three-property rule (although it may still work under the separate 200% rule).
If you have questions about any of these points or want to get clear on other questions about how 1031 exchanges work, please contact us. We will be happy to provide more information.