1031 Exchange Lowdown

Multi-asset Exchange

A multi-asset exchange involves both real and personal property. For example, the sale of a hotel will typically include the underlying land and building, as well as the furnishing and equipment. If the taxpayer wants to exchange the building for a similar property, he would exchange the land and building as one part of the exchange. The furnishing and equipment would be separated into groups of like-kinds or like-class property, with the groups of relinquished property being exchanged for groups of replacement property.

Read our previous post titled "Closing Costs on 1031 Exchange" to know about the closing costs in 1031 Exchange.

Properties That Can Be Identified

There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules"

• 3-Property Rule: The taxpayer may identify up to 3 potential replacement properties irrespective of their value
• 200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property
• 95% Rule: The taxpayers may identify as many properties as they want. However, before the end of the exchange period, the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.

Read our previous post titled "Identifying Replacement Property in an IRC 1031 Exchange", which provides useful information on 1031 Exchange.

Time Restrictions on Completing a Section 1031 Exchange

A taxpayer has 45 days after the date that the relinquished property is transferred to identify potential replacement properties. The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer's federal tax return for the year in which the relinquished property was transferred. For a calendar year, the exchange period may be cut short for any exchange that begins after October 17. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.

Read my previous post titled "Know More about Delayed Exchange Deadlines" for more interesting information on 1031 Exchange.

What is a Qualified Intermediary?

Qualified Intermediary (QI) is an independent party who facilitates tax-deferred exchanges in accordance with the Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person. Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer. The QI holds the sales proceeds to prevent the taxpayer from having actual or constructive receipt of the funds. Finally, the Qualified Intermediary acquires the replacement property and transfers it to the taxpayer to complete the exchange within the stipulated period.

Read my previous post titled "1031 Exchange Checklist" that provides a checklist on 1031 Exchange.

Benefits of Exchanging vs. Selling

Are you aware of the benefits of Exchange as compared to 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 return, you receive an interest free loan from the federal government in the amount you would have paid in taxes. The most important point is that you can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

In my previous post titled "Benefits of 1031 Exchange", I had provided some information on the benefits of 1031 Exchange. You can read that post.

Did You Know…

That both the taxpayer and the Exchange Accommodation Titleholder (EAT) must file their federal income tax returns separately? This clause is mandated by the IRS so that the agency is informed of any income generated and expenditure incurred while the EAT held title to the property.

Managing EAT-Held Property

In reverse exchanges that entitle Exchange Accommodation Titleholders to hold replacement property until a suitable buyer can be found for the taxpayer’s relinquished property, the EAT is the owner of the property only according to the title. The taxpayer is the actual owner in every other sense of the word.

The onus of all management, improvement and supervision tasks rest with the taxpayer. This is specially important in build-to-suit exchanges where the replacement property is acquired after certain improvements are made.

Interest(ing) Loans to EAT

A reverse exchange is characterized by a Qualified Exchange Accommodation Arrangement (QEAA) where an Exchange Accommodation Titleholder (EAT) takes title to your replacement property until you are able to find a suitable buyer for your relinquished property (in a swap-first reverse transaction, the EAT holds the relinquished property until you identify a suitable replacement property). In this arrangement, for the taxpayer to avoid constructive receipt, the EAT is required to contribute a part of the capital, from 5 to 20 percent, of the cost of the property.

Since the EAT does not get a return on these funds, as a general practice, the taxpayer or someone unqualified to be an EAT loans the funds to the EAT. This loan is interest-free, unless it is for a term greater than one year. But such a situation is unlikely to arise, since the taxpayer has to complete the transaction within 180 days of commencement.

The Growth Factor

In a 1031 exchange, once the relinquished property is sold, the proceeds of the sale are held in escrow. The interest earned on this amount is called the growth factor and has to be reported by the taxpayer as earned income. The amount is subject to tax unless it is used towards the purchase of the replacement property. 

Getting a Hold on Holding Period

The holding period has an important part to play in 1031 like-kind exchanges, more so because the IRS mandates that an exchange can take place and tax deferred only if the taxpayer shows intent to hold the replacement property for investment purposes. Tax benefits are not allowed if the IRS feels that the taxpayer has acquired the property in order to sell it immediately, either as it as, or after making improvements to it.

So how long should you hold on to the replacement property before it is safe to sell it? While the IRS does not fix a specific time period, it is a generally accepted rule that you retain ownership of the property for at least 12 months from the date of purchase. By that time, you would have gone through two tax cycles, and the IRS may be satisfied that you entered into the exchange for investment purposes.