01. 1031 Exchanges
Section 1031 of the Internal Revenue Code provides for the deferment of capital gain on the sale of real property when the sales proceeds are reinvested in replacement property as set forth in the provisions of Section 1031.
For most of its existence, Section 1031 required a taxpayer physically exchange real estate with a willing trading partner. However, as you can imagine, it is often difficult, if not impossible to find a willing trading partner, and this requirement hampered its use. To help alleviate the problems associated with finding a willing partner, congress amended Section 1031 to allow for the use of an intermediary and subsequently drop the requirement of a physical exchange between willing trading partners.
In a transaction using an intermediary, the taxpayer enters into a sales agreement to sell their property (the "relinquished property"), to a purchaser. Prior to the close of the sale, the taxpayer and intermediary enter into an exchange agreement wherein the taxpayer assigns the sales agreement to the intermediary who takes possession of the net sales proceeds of the relinquished property. The intermediary then holds these sales proceeds in trust for the taxpayer until the taxpayer can find a suitable replacement property.
Upon finding suitable replacement property, the taxpayer enters into a purchase agreement, and prior to the close of this sale, the taxpayer assigns the purchase agreement to the intermediary, who uses the sales proceeds that they are holding to cover the purchase price of the replacement property.
Identification of Replacement Property
The taxpayer has forty-five (45) days from the close of the sale of the relinquished property to locate and identify suitable replacement property. The identification of a replacement property does not mean the taxpayer has to buy the replacement property, but only means the taxpayer is interested in buying it as a replacement property.
The taxpayer may not use a property as replacement property if it is not timely identified within the 45-day period.
What is Like-kind?
Generally, all real estate is considered like-kind to all other types of real estate.
The following example might clarify this:
A pig farm in the Oklahoma panhandle is considered like-kind to a skyscraper in New York City because, while their uses are at opposite ends of the spectrum, they are nonetheless both forms of real estate, and considered like-kind.
How Many Replacement Properties can be identified?
In an exchange. the taxpayer may identify up to three (3) properties as replacement properties irrespective of their combined fair market value, or any number of replacement properties, so long as their combined fair market value does not exceed 200% of the value of the relinquished property.
Time Period for Purchasing a Replacement Property
The taxpayer has a total of 180 days from the sale of the relinquished property to close the sale of the replacement property(s).
Reverse 1031 Exchanges
A reverse exchange, as the title implies, involves a factual situation where it is necessary for the taxpayer to purchase the replacement property before the sale of the relinquished property.
While there are two primary means by which a reverse exchange can be structured, most reverse exchanges are structured where a middleman technically referred to as an exchange accommodation titleholder (“EAT”), takes title to the replacement property and holds title while the taxpayer completes the sale of the relinquished property. Simultaneous with or shortly after the close of the sale of the relinquished property, the EAT conveys the title of the replacement property to the taxpayer.
A construction exchange involves a situation where the taxpayer wants to use sales proceeds from the relinquished property to not only purchase a replacement property, but also to have a new structure constructed, or improvements made to existing structures.
This type of exchange is complex because improvements constructed after the taxpayer has acquired the replacement property is not considered like-kind to the relinquished property.
Nonetheless, such an exchange can be accomplished with an EAT taking title to the replacement property and holding title while the improvements are being constructed.
We understand real estate transactions. We have nearly two decades of experience in structuring exchanges and acting as an intermediary in the simplest to the most complex of exchanges. While the basic concept of an exchange may be the same, we usually have several variations and suggestions that will allow the taxpayer to choose the manner most advantageous to them.
In addition to our experience relating to exchanges, our founder and managing member is also an attorney specializing in real estate transactions. Therefore, we have experience not only in structuring the exchange and acting as the intermediary, but also with the rest of the real estate transaction. This includes title issues, escrow issues, and the vast other problems that often arise in a real estate transaction.
On numerous occasions our expertise in these other related areas have saved an exchange from failure.
Therefore, we believe we have something special to offer the taxpayer.
Moreover, we realize that in a real estate transaction, the intermediary is only one part of a usually fairly complex transaction, and that the taxpayer has a plethora of other issues on their mind. We pride ourselves in making the exchange process as simple and unobtrusive as possible for you!
To qualify for the deferral of tax from the sale of property the taxpayer has to purchase replacement property that is like-kind to the relinquished property.