- Q: Why should I do a 1031 Tax Deferred Exchange?
- A: These are just a few reasons why a Taxpayer should consider a 1031 exchange:
· Increase buying power because federal and state capital gain liability is deferred
· Estate preservation
· Exchange for property that cash flows
· Exchange for property that requires less management
· Consolidate several properties into one
· Exchange property from a run down location into a better location
· Exchange one large property into several properties to leave for heirs
- Q: Who (and when) do I need to notify that I want to do a 1031 tax deferred exchange?
- A: Ideally, Taxpayer knows that he wants to do an exchange before signing the sales contract. Your realtor would be putting on the contract stating that you are going to do a 1031 exchange. Then you should call or E-mail CLX for your FREE consultation and to set up a new exchange (see How to Get Started). Make sure you contact CLX before the first closing involving exchange properties takes place.
- Q: What types of properties do not qualify for a 1031 exchange?
- A: Stocks, bonds, notes; interest in a partnership; stock in trade or other property held primarily for sale.
- Q: Can 1031 exchange be used for a primary residence?
- A: No. Section 1031 applies only to investment properties. However, sometimes Taxpayers acquire a property through a 1031 exchange, rent it out for a couple of years, then make it their primary residence. A property acquired through a 1031 exchange, and later converted into a primary residence, must be owned by Taxpayer for five years from the date of the exchange before Taxpayer can claim the capital gains exclusion. Thus, to utilize a 1031 exchange and the capital gains exclusion on the primary residence, Taxpayer must both have used the property as primary residence for 2 years, and owned it for 5 years.
- Q: If the title to Relinquished property is held in the name of a LLC, can I purchase Replacement property in the name of a revocable living trust?
- A: No. The same taxpayer who sold the Relinquished property must acquire the Replacement property to satisfy the exchange requirements of Section 1031.
However, a few exceptions apply to single member LLCs and community properties located in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin (i.e. community property states). For further details, please call CLX.
- Q: Can I take some cash out and still do an exchange?
- A: Yes. It is called “partial exchange”, when a certain amount of proceeds go into the exchange for a replacement property, and the rest goes to Taxpayer. Cash received at the closing is called “boot” and is taxable.
Taxpayer should notify his QI and closing agent before the closing if he wants to receive cash from the sale of the relinquished property.
- Q: Can I refinance before or after an exchange?
- A: It is better to refinance after the exchange. If you decide to borrow against your Relinquished property right before the exchange, the IRS might consider it an early disbursement of the exchange equity, and you might be taxed on that amount. On the other hand, if you borrow against the Replacement property, you just acquire more debt, which you expect to repay.
- Q: If I decide not to purchase any replacement properties, when will I have access to my money?
- A: There are quite a few scenarios of funds release to taxpayer;
· If you have not identified any properties within 45-day period, CLX will release exchange funds to you after the 45th day.
· If you have identified replacement property, and you are past the 45th day, and decide not to do the exchange, CLX will hold your funds until 180th day, and will release them to you on at the end of the exchange.
· If you have identified replacement properties, purchased all of them, and still have some funds left over, CLX will return the excess funds to you after the purchase of the last property, if you are past your 45th day.
Keep in mind that QI is required to hold the exchange funds for at least 45 days. Before the end of the exchange QI can release exchange funds only for the purchase of the replacement property or earnest money deposit.
- Q: What is “boot” anyway?
- A: Any consideration received other than “like-kind” property, is considered “boot” and is taxable.
There are 2 general types of boot:
1. Cash Boot can be received at the time of the sale of relinquished property, if Taxpayer chooses to take some cash out for personal needs. Cash can also be received after Taxpayer has completed the exchange, and the replacement property cost was less than what the relinquished property sold for.
2. Mortgage or Debt Reduction Boot occurs when Taxpayer’s debt on replacement property is less than paid-off debt on the relinquished property. As with cash boot, mortgage boot can occur when Taxpayer is “trading down” in the exchange.
Rule of Thumb: To avoid paying taxes, Taxpayer should always purchase a property of equal or greater value, acquire equal or greater debt on the replacement property, and use all of the exchange proceeds.
Note: Taxpayer may replace debt on the replacement property with cash instead of obtaining a new loan.
- Q: How do I identify replacement property?
- A: IRC Section 1031 states that like-kind exchange property is identified as “property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange.” According to IRC Section 1031, it is the “requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property.“
§1.1031 (k)-1: “The Replacement property is identified only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of identification period to” “the person obligated to transfer the replacement property to the taxpayer”. CLX provides its customers with Identification Forms to identify the property of their choice.
- Q: Can I identify as many properties as I want?
- A: Exchanger may identify up to three properties with no restrictions to their fair market value. If Exchanger identifies more than three properties, their combined fair market value cannot exceed 200% (double) of the sales price of the Relinquished property. Exchanger is not obligated to purchase all identified properties but must purchase at least one of the properties to qualify for capital gains deferral.
- Q: How much time do I have to purchase the replacement property?
- A: The Replacement property has to be acquired before “the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor’s tax return … for the taxable year in which the transfer of the relinquished property occurs”. For example, Taxpayer closed on Relinquished property on December 31, 2005. His 180th day falls on June 29, 2006 (past the deadline for filing 2005 tax returns—April 15, 2006). He can take advantage of the full 180-day period by filing an extension with the IRS. If he does not file the extension, his exchange will end on April 16, 2006.
- Q: Can I purchase a second or vacation home through a 1031 exchange?
- A: If structured properly, the transaction might qualify for a 1031 exchange. You will have to limit personal usage of the home to less than 14 days or 10% of rented days a year, and deduct your expenses as on an investment property.
- Q: Can I combine multiple relinquished properties into one replacement property?
- A: Yes. But remember that the exchange starts at the time your first relinquished property sells, and you will have to sell ALL of the relinquished properties before you can acquire a replacement property within a 180-day period.
You can also sell one relinquished property and obtain multiple replacement properties under one exchange agreement.
- Q: For how long should I hold the Replacement property acquired through a 1031 exchange?
- A: The IRC regulations do not specify a particular holding period, except for exchanges between related parties. The IRS is looking for proof of the Taxpayer’s intent to hold the property for investment purposes. If the replacement property is sold soon after it was acquired, it might be determined that it was purchased for resale, and 1031 exchange will be disqualified.
Tax and legal professionals generally consider two years is to be a safe period.
- Q: Is it possible to defer paying capital gains taxes indefinitely?
- A: Yes. There is no limit to the number of 1031 exchanges that a taxpayer can participate in. Taxpayer can continue to defer capital gains taxes by either further exchanging the replacement property for another like-kind property, or by holding on to it, until the taxpayer dies. The taxpayer’s estate will not have to pay capital gains tax on the deferred gain. There will be a step up in basis to the market value of the property at the taxpayer’s date of death. Later, when the estate or heirs sell the property, they will only pay tax on the increase in value after the taxpayer’s death.
- Q: Can my attorney or accountant be my QI? And does CLX give a tax or legal advice to its customers?
- A: QI within the meaning of Treas. Regulations § 1.1031(k)-1(g)(4) is a person who “is not the taxpayer or disqualified person.” Disqualified person is defined as “the agent of the taxpayer at the time of the transaction.” “A person who has acted as the taxpayer’s (…) attorney, accountant, (…) or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction.”
CLX strongly recommends that our customers consult their own accountants and/or attorneys for all tax advice regarding their particular situation.