The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers investors one of the last great opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of their equity into the replacement property. Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire "like kind" replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).

In any exchange the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.

Important Considerations for an Exchange

Exchanges must be completed within strict time limits. The Exchanger has 45 days from the date the relinquished property closes to "Identify" potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. After the 45 days has passed, the Exchanger may not change their Property Identification list and must purchase one of the listed replacement properties or the exchange fails!

• To avoid the payment of capital gain taxes the Exchanger should follow three general rules: (a) purchase areplacement property that is the same or greater value as the relinquished property, (b) reinvest all of the exchange equity into the replacement property and (c) obtain the same or greater debt on the replacement property as on the relinquished property. The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.
• The Exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes.
• IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.
• Investment Property Exchange Services, Inc. is available to assist Exchangers and their advisors with their exchange strategies. The Exchanger is always advised to discuss the intended exchange with their legal or tax advisor

Tax Deferred Exchange Terminology

As with any other specific area of real estate law, tax deferred exchanges under IRC §1031 have their own language, which may be confusing to those who are unfamiliar with these transactions. The following are some of the exchange terms and phrases that are often used with their "plain-English" interpretations.

1. Boot- Fair Market Value of non-qualified (not "like-kind") property received in an exchange. (Examples: cash, notes, seller financing, furniture, supplies, reduction in debt obligations.) Receipt of boot will not disqualify an exchange, but the boot will be taxed to the Exchanger to the extent of the recognized gain.

2. Constructive Receipt- A term referring to the control of proceeds by an Exchanger even though funds may not be directly in their possession.

3. Exchanger- The property owner(s) seeking to defer capital gain tax by utilizing a IRC §1031 exchange. (The Internal Revenue Code uses the term "Taxpayer.")

4. Like-Kind Property- This term refers to the nature or character of the property, not its grade or quality. Generally, real property is "like-kind" as to all other real property as long as the Exchanger´s intent is to hold the properties as an investment or for productive use in a trade or business. With regards to personal property, the definition of "like-kind" is much more restrictive. (See Brief Exchange, Like-Kind Property.)

5. Qualified Intermediary- The entity that facilitates the exchange for the Exchanger. Although the Treasury Regulations use the term "Qualified Intermediary," some companies use the term "facilitator" or "accommodator".

6. Relinquished Property- The property "sold" by the Exchanger. This is also sometimes referred to as the "exchange" property or the "downleg" property.

7. Replacement Property- The property acquired by the Exchanger. This is sometimes referred to as the "acquisition" property or the "upleg" property.

8. Identification Period- The period during which the Exchanger must identify Replacement Property in the exchange. The Identification Period starts on the day the Exchanger transfers the first Relinquished Property and ends at midnight on the 45th day thereafter.

9. Exchange Period- The period during which the Exchanger must acquire Replacement Property in the exchange. The Exchange Period starts on the date the Exchanger transfers the first Relinquished Property and ends on the earlier of the 180th day thereafter or the due date (including extensions) of the Exchanger´s tax return for the year of the transfer of the Relinquished Property.

What Property Qualifies for IRC §1031 Treatment?

To qualify for a tax deferred exchange under IRC §1031 both the relinquished and the replacement properties must be held by the Exchanger for investment purposes or for "productive use in their trade or business". The Exchanger´s purpose and intent in holding the property, rather than the type of property, is the critical issue. The use of the property by the other parties to the exchange (buyer and/or seller) is irrelevant. The following are examples of qualifying properties:

• Bare land Farmer´s farm
• Commercial rental Residential rental
• Industrial property Doctor´s own office
• 30-year leasehold interest Percentage interest in investment property

Under IRC §1031 the following properties do not qualify for exchange purposes:

• Stock in trade or other property held primarily for sale (Note: this includes property held by a developer or other dealers in property);
• Securities or other evidences of indebtedness or interest;
• Stocks, bonds, or notes;
• Certificates of trust or beneficial interests;
• Interests in a partnership (Note: the partnership can elect out of partnership status under IRC §761(a));
• Choses in action (this is a right to receive money or other personal property by judicial proceeding).

It is important to note that the intent by the Exchanger to hold the property for personal use will prevent the property from qualifying for exchange treatment. Therefore, second homes will not qualify for tax deferred exchange treatment unless the taxpayer changes how they treat or use the second home. For example, a taxpayer could "convert" their second home to a valid exchange property and establish this intent by properly renting the property and holding it as a legitimate rental property. See Rev. Rul. 57-244, 1957-1 C.B. 247. However, the taxpayer cannot just simply rent the taxpayer´s residence and expect it to automatically qualify for exchange treatment. Bolaris v. C.I.R., 776 F.2d 1428 (9th Cir. 1985). Many taxpayers own vacation homes, which are rented out during the time when the taxpayer is not using the home. Even though under IRC §280A a vacation home may have a portion of its deductions disallowed if it is used for personal purposes under the "14-day rule", an Exchanger can argue that if the vacation home is partially used in a trade or business (renting it), the vacation home should be eligible for tax deferred exchange treatment upon it sale. However, there may need to be a bifurcation of uses as is also required for a home office use in a personal residence. Rev. Rul. 82-26, 1982-1 C.B. 115.

In many instances taxpayers use a part of their personal residence for a home office for business purposes. In this case when the taxpayer sells the personal residence, the transaction must be split such that the portion used for business purposes is treated separately for tax purposes from the portion used for a personal residence. Rev. Rul. 82-26, 1982-1 C.B. 115. The taxpayer could then qualify the entire transfer for tax-free treatment; the business portion could qualify for a tax deferred exchange under IRC §1031 and the personal residence portion could qualify for a tax-free sale under IRC §121 provided the transaction otherwise met the exemption requirements of IRC §121. Naturally, consultation with a tax advisor is important whenever a taxpayer changes how they intend to hold property.

Information provided in cooperation with IPX 1031 (Investment Property Exchange Services, Inc.).

For a FREE copy of the booklet "Brief Exchanges" (Save on Capital Gain Taxes with a Like-Kind Exchange) describing in more detail a 1031 exchange, please, Email us at Larry@ocreonline.com and provide us with your name, address, telephone number, Email address. Ask for 1031 Booklet and a copy will be sent to you.

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