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General Questions Identification Rules Exchange Timelines Related Party IRS Reporting

1031 Exchange Rules and FAQ

GENERAL QUESTIONS
Do I have to spend everything in my 1031 account?
No, you do not have to spend all of your funds. However any amount not spent will be considered cash boot and will be subject to capital gains taxes and any applicable recaptured depreciation. For example: The Relinquished (sold) property is sold for $500,000.00. The Acquired (bought) property is bought for $400,000.00. The $100,000.00 would be considered cash boot and would be taxable.

Can I finance the sale of my property (seller carry back note)?
Yes. However, to have a full tax deferred exchange all notes must be paid by buyer and the acquired property must close within the 180 day period. If the notes are not paid within 180 days then the portion of the exchange proceeds in the 1031 Exchange can be exchanged for like kind property and the funds from the note are classified as an installment sale and are taxable when received.

Example 1
Relinquished property sells for $500,000.00. Buyer pays $200,000.00 cash and seller gives a $300,000.00 carry back note with a term of 3 months. The $200,000.00 is placed in the 1031 Exchange account and the $300,000.00 note is made payable to the Exchange Accommodator. When the 3 month term is up the buyer pays the $300,000.00 to the Exchange Accommodator and the taxpayer (seller) buys replacement property for $500,000.00. This is a fully deferred exchange.

Example 2
Relinquished property sells for $500,000.00. Buyer pays $200,000.00 cash and seller gives a $300,000.00 carry back note with a term of 3 years. The $200,000.00 is placed in the 1031 Exchange account and the $300,000.00 note is made payable to the Seller. Seller then buys replacement property for $200,000.00 and receives payment on the note in installments. This is a partial exchange and the note installment proceeds are taxable when received.

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Can I get legal or tax advice from you?
No, the IRS doesn't allow us to act as both your qualified intermediary and your attorney or tax advisor. So we will work with your attorney and CPA to make sure your tax-free exchange goes smoothly.

What kind of real estate qualifies for a 1031 exchange?
Almost every kind of real estate is considered "like kind" and can be exchanged for any other real estate, including vacant land for apartments, a rental house for a shopping center, an office building for a leasehold interest with 30 years or more remaining, as long as you hold them for investment or business use. There are a few exceptions (REITs) so please check with us on specific properties.

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How can I qualify to pay NO taxes when I sell my property?
Any investor can qualify! Section 1031 of the IRS code lets you sell your property and buy a new property without paying any taxes. You simply follow specific rules. That's where we come in. As a professional qualified intermediary, we'll help you qualify and gain the advantages of a 1031 tax free exchange.

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What is a qualified intermediary?
That's us. The IRS says if you touch the money you pay the tax. However, if you use a qualified intermediary to transfer the money from the sold property into the purchased property, you qualify for a tax free exchange. The IRS does not permit your accountant, attorney, or escrow company to be your qualified intermediary. As a professional qualified intermediary, we are members of the Federation of Exchange Accommodators and bonded. Click Here to View our Bond


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Why is an accommodator needed?

Can the taxpayer just sell the relinquished property and put the money in a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.

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Can I get legal or tax advice from you?
No, the IRS doesn't allow us to act as both your qualified intermediary and your attorney or tax advisor. So we will work with your attorney and CPA to make sure your tax free exchange goes smoothly.

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Can I avoid paying taxes forever?
Yes, you can. By simply following the 1031 exchange rules every time you sell one or more properties and buy replacement properties, when you die your estate escapes all the capital gains taxes forever!

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What exactly are the tax advantages in exchanging?
You can eliminate paying any capital gains taxes, and you can eliminate paying the even higher-rate taxes on the recapture of depreciation you've taken on your property. By exchanging into a higher priced property you'll also gain additional depreciation deductions which can increase your after-tax income.

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Are there reasons to exchange other than tax advantages?
Yes, there are many non-tax reasons to exchange. For example, if you no longer like managing property, you can exchange your management intensive property for triple-net management free property, or exchange multiple smaller properties for one that can be professionally managed. Or, say your current property cannot be easily refinanced. You could exchange out of that property for a new property which could be refinanced more easily so you can take some cash out. Or, you might exchange to improve cash flow

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What kind of real estate qualifies for a 1031 exchange?

Almost every kind of real estate is considered "like kind" and can be exchanged for any other real estate, including vacant land for apartments, a rental house for a shopping center, an office building for a leasehold interest with 30 years or more remaining, as long as you hold them for investment or business use. Check with us on the specific properties.

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Can I buy a new property before selling my old one?

Yes, you can buy a new property before selling the old property and still qualify - it's called a "reverse" exchange. The qualified intermediary takes title to the new property you buy and holds it for you until you sell your old property.

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Can I get money out of the exchange tax free?
Yes, one way is to complete the exchange first and then refinance the new property.

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Can I use my IRA in conjunction with a 1031 Exchange?
Yes, if you do it right. Using an IRA for real estate requires a special Self-Directed IRA. Your Self-Directed IRA at Charles Schwab or Fidelity does NOT permit you to hold real estate or any asset other than securities. This can be solved by moving your IRA to a custodian that allows for real estate in the plan document. With the right Self-Directed IRA (known as Real Estate IRA) and proper structuring, you partner with your IRA to buy leveraged real estate. When it comes time to sell, you can 1031 your portion of the gain while the IRA gets its portion of the gains tax exempt.

For more information on how you can use an IRA to purchase real estate please visit www.MyRealEstateIRA.com or email 1031@MyRealEstateIRA.com


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How do I exchange into a larger property (trade up)?
You trade up by getting a bigger loan on the new property, or adding cash, or equities in other properties, or notes carried back from the sale of other properties, etc. Done right, it's all tax free.

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Can I refinance without blowing the tax free exchange?
Yes, you can refinance the property you are selling before you exchange, or refinance the property you are buying after you exchange, and the proceeds are tax-free. Check with us for the details as the timing and contract dates are critical.


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Can I carry back a loan on the property I'm selling and still have a tax free exchange?
Yes, the payments you receive are taxed as you get them, on an installment sale basis. The balance of your equity is exchanged tax free.

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I've already sold my property. Can I still do an exchange?
Yes, provided your sale has not closed yet, simply contact us and we will turn your taxable sale into a tax free exchange with some simple paperwork. You can call us right up until the day before closing.

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Do I have to spend all of the 1031 exchange proceeds?
No, you do not have to reinvest 100% of your net sales proceeds, however the amount that you do not reinvest will be subject to depreciation recapture and capital gain income tax liabilities. This is called trading down in value or completing a partial 1031 exchange and will result in mortgage boot and/or cash boot.  You will need to reinvest 100% of your net sales proceeds if you want to defer 100% of your income tax liabilities.

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1031Click here for Boot Definitions
I bought my property as a single person but would like to buy with a spouse. Can I do this and still have a valid exchange?
Most tax professionals advise that the best and safest way to complete this exchange is to purchase as a single person and then add the spouse or at a later date after the completion of the exchange. The spouse may be also added to the title of the relinquished property if the exchange is planned ahead of time.

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What is the difference between "realized" gain and "recognized" gain?
Realized gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.

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What is Boot?
Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.

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What is Mortgage Boot?
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.

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What is Cash Boot?
Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.

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Can I sell more than one relinquished property in the same 1031 exchange?
Yes. There is no limit as to how many relinquished properties or how many like-kind replacement properties you can have within the same 1031 tax-deferred exchange transaction. As long as the aggregate value of all of the relinquished properties is equal or greater than the purchase price of the acquired property you will still have a valid 1031 exchange.

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What if I have already signed a contract to sell the relinquished property, is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred Exchange. Once the closing occurs, it is too late to take advantage of a 1031 exchange (even if the taxpayer has not cashed the proceeds check).

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What are the general guidelines to follow in order for a taxpayer to
defer all the taxable gain?
* The value of the replacement property must be equal to or greater than the value of the relinquished property.

* The equity in the replacement property must be equal to or greater than the equity in the relinquished property.

* The debt on the replacement property must be equal to or greater than the debt on the relinquished property.

* All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.

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When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds can only be
withdrawn in accordance with the Regulations. The taxpayer cannot
receive any money until the exchange is complete. If you want to receive
a portion of the proceeds in cash, this must be done before the funds
are deposited with the Qualified Intermediary.

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Can I defer my taxes to the future and pay the old tax rate?
No, The current tax rate will be charged when you defer taxes but it will be based on your gain from the first and all subsequent transactions.
What are the benefits of exchanging v. selling?
  • A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
  • By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes.
  • Any gain from depreciation recapture is postponed.
  • You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
What are the general guidelines to follow in order for a taxpayer to defer all the taxable gain?
  • The value of the replacement property must be equal to or greater than the value of the relinquished property.
  • The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
  • All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
Can the taxpayer just sell the relinquished property and put the money in a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.
Can I exchange into a vacation home?
Revenue Procedure 2008-13 provides that a vacation or second home will qualify for tax-deferred exchange treatment if:

It is owned by the taxpayer for at least 24 months immediately before the exchange ("qualifying use period"); and
Within the qualifying use period, in each of the two 12 month periods, (1) the taxpayer rents the dwelling unit at fair rental to another person for 14 days or more and (2) the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit was rented at fair rental value. 

A vacation or second home will qualify as like-kind replacement property if:
It is owned by the taxpayer for at least 24 months immediately following the exchange ("qualifying use period"); and -

Within the qualifying use period, in each of the two 12 month periods, (1) the taxpayer rents the dwelling unit to another person at fair rental for 14 days or more and (2) the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12 month period that the dwelling unit was rented at fair rental. 
Can I move into a property then sell it and use my $250,000
/$500,000 residential tax break?
On July 30, 2008, President Bush signed the Housing Assistance act of 2008 that includes a modification to the Section 121 exclusion. This provides an exclusion of gain on the sale of a primary residence.

Section 121 allows a taxpayer to exclude up to $250,000 ($500,000 married filing jointly) of gain on the sale of a primary residence as long as they have lived in the property for 2 out of 5 years preceding the sale.

Under the new law, which is effective January 1, 2009, the Section 121 exclusion will not apply to gain from the sale of the residence that is allocable to periods of “nonqualified use”. Nonqualified use refers to periods that the property is not used as the taxpayer’s principal residence.

However, this change only applies to time periods prior to conversion into a personal residence. If a taxpayer converts a primary residence to rental and never converts the property back to primary use, then the $250,000 exclusion of gain is still valid.

For example, a taxpayer exchanged into a property through a 1031 exchange and rented it for 4 years. The taxpayer then decides to move into the property, convert its use to primary residence for 2 years then sell the property and realize $250,000 of gain. Under the old law, this gain would be excluded under Section 121. Now, the 121 exclusion is prorated for the periods of time that the property was held for nonqualified use. This means that 4/6 or 4 out of 6 years of gain is ineligible for the $250,000 exclusion.

 
IDENTIFICATION RULES
When must I identify?
You must identify the replacement property(ies) within 45 days of the close of escrow of the relinquished property.
Who can I identify to?
The IRS states that identification must be in writing, signed by you and delivered to a person involved in the exchange like the qualified intermediary.
What constitutes a valid identification?
A valid identification will have the replacement properties clearly described. In the case of real estate, this means the legal description, street address or distinguishable name.
What are the Identification “rules”?
If I cannot purchase property that I identify can I substitute other properties?
If the taxpayer is within the 45 day identification period, correction or substitutions may be made to the identification. If the taxpayer has identified property and has past the 45 day identification period and cannot close on ALL properties listed, the accommodator must hold any remaining funds until midnight of the 180th day of the exchange.
1031Click here for document

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EXCHANGE TIMELINES
How long do I hold the property if I want to exchange it?
There is no holding period. You can exchange the day after you buy a property. Remember you don't want to be considered a dealer or speculator so be certain not to have a contract on the record to SELL before you have actually closed on the property you are BUYING..but you can enter a contract to sell right after you buy.
What are the 45 day and 180 day deadlines and what do they mean?
Property(ies) to be acquired must be identified and delivered by midnight of the 45th day following the date of close of the relinquished property. All replacement property(ies) must close escrow by midnight of the 180th day following the date of close of the relinquished property.

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How long do I have to hold title to qualify for a 1031 Exchange?

There are no actual holding rules given by the IRS. Many tax advisors advise that the property be held at least 12 moths prior to the exchange.

The amount of time the property is held is not the only thing the IRS looks at when determining the validity of a 1031 Exchange. Another important factor is the intent to hold the property for business or investment use.

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Can I extend the 45 or 180 day limits?

For the most part the answer is no. However, the IRS has issues extensions to areas affected by natural disasters. Your accommodator will have the latest information regarding limit extensions. An example of an extension issued by the IRS is here.

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What happens if I sell my relinquished property and the 180 day limit ends after the tax filing deadline of April 15th of the following year?
The exchange must be completed by the tax filing date of April 15th unless a taxpayer files for an extension to file federal and state tax returns. Once the extensions of time have been filed, you must complete your 1031 exchange transaction within the 180 days before you actually file your Federal and state income tax returns.

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RELATED PARTY
What is a related party?
Related parties include, but are not limited to, immediate family members, such as brothers, sisters, spouses, ancestors and lineal descendents. A corporation, limited liability company or partnership in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interest or profits interest owned by the taxpayer is also considered to be a related party. The executor of an estate and the beneficiary of the estate in a trust are also considered related parties.

Can I exchange with a related party?
The IRS has issued Revenue Ruling 2002-83 which describes its position on related party exchanges.Click here for document

A taxpayer can SELL a property to a related party and acquire like-kind replacement property from a non-related party without violating 1031 rules, however both parties must hold the respective properties for a minimum of 2 years to qualify. The IRS has offered several private letter rulings which may dispose of the 2 year holding period for the related buyer.

Click to view a selected private letter ruling:

PLR200709036
PLR200712013
PLR2007280108

A taxpayer cannot SELL and BUY property from a related party unless both parties are completing their own 1031 Exchange or can prove that the transaction was not completed to avoid taxes. A taxpayer also cannot sell to an unrelated party and buy from a related party.

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EXPLANATIONS
3 Property Rule
The three (3) property identification rule limits the total (aggregate) number of like-kind replacement properties that you can identify to three (3) potential like-kind replacement properties.  The vast majority of Investors today use this three (3) property identification rule.

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200% of Fair Market Value Identification Rule
You can identify more than three (3) like-kind replacement properties as long as the total (aggregate) fair market value of all the identified like-kind replacement properties does not exceed 200% of the total (aggregate) net sales value of your relinquished property(ies) sold in your 1031 exchange.  The limitation is only on the total (aggregate) identified value.  There is no limitation on the total number of like-kind replacement properties.

For example, if you sold relinquished property(ies) in the amount of $2,000,000 you would be able to identify as many like-kind replacement properties as you want as long as the total (aggregate) value of the identified like-kind replacement properties does not exceed $4,000,000 (200% of $2,000,000).

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95% Identification Exception
Its good to have choices, but be careful with this exception.  It is an exceptionally useful tool under the right circumstances, but can present some tricky problems. 
You may need to identify significantly more like-kind replacement properties than the first two identification rules permit.   There is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified.
However, if you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties the entire 1031 exchange transaction will be disallowed.

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IRS REPORTING
IRS Form 8824: Like Kind Exchanges
Requires that you provide the IRS with the description of your relinquished and replacement properties, the date your relinquished property was acquired by and conveyed to the buyer, the date the like-kind replacement property was identified to your Qualified Intermediary by you, and the date the like-kind replacement property was acquired by and conveyed to you. These last two (2) items are to ensure that you have complied with the 45 calendar day identification rule and the 180 calendar day 1031 exchange period. IRS Form 8824 also asks for any related party information. Click here to download IRS Form 8824

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IRS Form 4797: Reporting Gain
Any taxable gain recognized will be reported on IRS Form 4797 or Schedule D depending on the character of the relinquished property. Your taxable gain must be allocated between ordinary income depreciation recapture, unrecaptured Section 1250 taxable gain, Section 1231 taxable gain, and capital gain.

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IRS Form 6252: Installment sales
You may be able to report all or a portion of the taxable gain under the installment sale basis pursuant to Section 453 of the Internal Revenue Code if you accepted a seller carry back note as part of the consideration from the buyer of your relinquished property by completing IRS Form 6252

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*1031 Exchange Advantage ™, a tradename of 1031 EA, LLC, is a qualified intermediary as required by the IRS to facilitate your exchange and does not provide legal or accounting services. All information contained herein is for informational purposes only. Please consult your attorney or accountant for legal or accounting advice.
FEA Member
1031 Exchange Advantage ™, a tradename of 1031 EA, LLC, currently uses Citibank, N.A. and California Republic Bank, member FDIC, among others.

*Exclusive accommodator to many fine Brokerages nationwide such as Prudential Douglas Elliman, New York, New York
Corporate Headquarters: 5355 Avenida Encinas, Suite 203 • Carlsbad, CA 92008 • Direct: 1.866.944.1031
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