Section 1031 Exchange Q&A
The exchange process can be very complicated, requiring intimate understanding of the tax code and related law. These questions cover only the most common questions raised by our clients, and do not cover all conditions, restrictions and stipulations. For more complete assistance, call The Exchange Connection, or contact us via email.
Q: To qualify for a Section 1031 Tax deferred Free Exchange, do I have to find someone with whom I must exchange properties?
Although you may certainly do a direct trade with someone, finding someone with property you want that is willing to trade with you is extremely rare. Most exchanges resemble a traditional property sale and purchase transaction. The difference between a traditional sale and re-purchase is in how the money is transferred, how the transaction is documented, and how the transaction complies with the governing regulations.
Q: What is a "like-kind" property?
A: With reference to real estate the term "like-kind" simply means that real property must be exchanged for real property. For example, a rental home may be exchanged for an apartment complex, a shopping center for an orchard or a ranch for a medical center. In the area of personal property exchanges the rules are more restrictive and an airplane must be exchanged for another airplane and not a boat even though they are both a means of transportation. In the area of personal property you should discuss your specific case with one of our legal or accounting staff. Keep in mind however, that whether real property or personal property it must be used as a business or income producing asset or held for investment to qualify. If you are not sure if your asset qualifies give us a call, there may be ways to structure the transaction to make them qualify.
Q: What is the advantage in replacing my existing property with a "like-kind" property, and what happens if I can't find such a property?
A: The advantage of doing an exchange is that you can shelter your gain from taxation. If you have a $100,000.00 gain on the sale of your property you can save $25,000 in federal tax and another $4,000.00 to $10,000.00 in state income taxes (depending on your state rate) simply by purchasing a qualified replacement property. If you start the process of an exchange and for any reason can't find a suitable replacement property, you simply cancel the exchange and report the transaction as a sale.
Q: Can I exchange a single property for multiple properties or vice versa?
A: Yes. You can diversify your investments from a single property to two or more Replacement properties. For example, you can exchange a farm for a medical building and an apartment building and a vacation condo that you rent out. You can also consolidate your smaller properties into a single, more manageable property. For example, you can exchange several single family rental properties into one larger apartment building. This consolidation may allow you to use on site management and reduce the burdens of being a landlord.
Q: Can I exchange my property for a partial interest in a different property and vise versa?
A: Yes and No. You can exchange your 100% interest in a property for a fractional interest (e.g. 50%) of another property provided you do not create a partnership. You may also exchange a tenancy in common interest for an undivided interest. This is a very complex area and the answer to the question can change with small changes in the facts of your particular situation. Call one of our exchange experts to discuss the details of your particular fact pattern.
Q: Do I need to re-invest all the cash that comes from the sale of my Relinquished Property or can I keep some?
A: You can retain some of the cash but you will be taxed on the full amount that you keep. This is called "Taxable Boot" and there are complex regulations on how and when you may receive the funds. If you wish to complete an exchange but keep some of the cash, you need to consult a knowledgeable and experienced qualified intermediary. The qualified intermediary must create the proper documentation and disbursement controls to allow for the partial release of cash. If this is not done properly you will disqualify your entire exchange and be taxed on 100% of the gain!
Q: Does the sale of my "Relinquished" property have to close simultaneously with the purchase of my "Replacement" property?
A: No. Most exchanges today are "Delayed" Exchanges. Section 1031 gives the taxpayer 180 days from the transfer of the Relinquished property to acquire the Replacement Property.
Q: What happens if I need to buy my Replacement property before my Relinquished property sells?
A: We can structure a "Reverse Exchange" which will qualify for 1031 exchange treatment. This involves a complex and specific exchange process that must be performed by a knowledgeable and experienced qualified intermediary.
Q: Can I exchange property between states?
A: Yes. For federal tax purposes you can exchange across state lines without any problems and avoid up to 25% of federal tax. However, each state has its own treatment of cross border transactions. For example, Oregon recognizes 1031 exchanges (no tax due) of Oregon property for property in another state, provided, you are an Oregon resident. However, if you are an Oregon non-resident that owns property in Oregon being exchanged for property in another state, you must pay the Oregon tax. Tax treatment of cross border 1031 exchanges varies with each state and you need to review tax policy for the states in question as part of the decision making process.
Q: Can I exchange a foreign property for a domestic property, or vice-versa?
A: No. Property located in the United States is not considered "like-kind" in relation to property located in a foreign country.
Q: I have property in Puerto Rico. How does Section 1031 define "United States"?
A: Section 1031 does not typically consider commonwealths like Puerto Rico and Guam as qualifying under the definition of "United States". The code only identifies states and the District of Columbia as falling under the geographic definition of the "United States". However, a precedent has been set where a Virgin Island property qualified. If you have property in a commonwealth, it may be in your best interest to contact The Exchange Connection for more information.
Q: Is Real Estate the only asset I can exchange under Section 1031?
Section 1031 applies to all assets used in trade or business, for investment purposes. Personal property may also be exchanged, but the qualifications for a "like-kind" exchange are more restrictive for personal property. Property that may qualify include boats, farm equipment, trucks and planes.
Q: Are there any types of assets specifically excluded in Section 1031?
A: Yes. Exclusions include: Stock in trade or property held primarily for sale (e.g. inventory); Securities or evidences of indebtedness or interest (e.g. stocks, bonds and promissory notes); Interests in a partnership; Certificates of trust or beneficial interest; Choses in action
Q: What disadvantages should I be aware of when engaging in a Tax Deferred Exchange?
A: The biggest disadvantage of doing a 1031 tax deferred exchange is the limited time frame in which you must complete the transaction and the modest cost. Given the tremendous tax saving opportunity most people find the advantage far outweighs the cost.
Q: Is there a difference in qualified intermediaries?
A: Absolutely! The success or failure of your exchange depends on the expertise and documentation prepared by the qualified intermediary. You need to know that no formal training is required nor any special testing, background check, or licenses are needed to be a qualified intermediary. Unless you know the reputation and qualifications of the qualified intermediary you hire, you could be getting "best guess" information from unqualified people using documents that were not drafted or reviewed by a qualified tax attorney. Most qualified intermediary companies do not review your transaction in any manner nor do they check to see if mistakes are being made at other levels that could jeopardize its qualification as a section 1031 exchange. Having your exchange handled by an exchange clerk is like having surgery done by a medical assistant, you might get lucky. Section 1031 exchanges are a complex legal and tax based transaction that requires skill and expertise to be handled properly. At the Exchange Connection, we review every level of the documentation, from the purchase and sale agreements to the escrow instructions to the settlement statements to spot potential pitfalls and errors that could cause you problems in the future. We treat each exchange like the important and complex transaction that it is. We pay attention to detail and devote the professional attention that your transaction deserves. We do not stuff your information into "cookie cutter" documents and hope for the best. Our documents were drafted by a qualified tax and real estate attorney and CPA and are continuously refined to reflect the latest developments in the law.