1031 Exchange Lowdown

Know Permissible Settlement Costs

Quite a few people believe that the proceeds you earn from a tax-deferred like-kind exchange cannot be used for many things. Fact is these proceeds can be used to pay for certain routine permissible transaction, or settlement and closing costs related to the disposition of the relinquished property. It can also be used to acquire the like-kind replacement property without creating an income tax liability for you, the investor.

While you can pay other expenses , financing costs and settlement charges with these proceeds, it may be a costly proposition. These expenses will be considered to be cash boot received by the investor. This may therefore result in an income tax liability (non-permissible expenses and closing costs). In certain situations, cash boot paid can be offset by cash boot received and will reduce the Investor's income tax liability. Exeterco.com reports:

Investors should therefore always review their estimated settlement statement and/or HUD-1 statement with their tax and/or legal advisers prior to approving the estimated expenses and closing costs to ensure they have a complete understanding of the income tax consequences from the transaction prior to the closing of the transaction.

Read more: 1031 Exchange Permissible and Non-Permissible Closing/Settlement Costs

The Rule Of 3

Did you know about the three (3) property identification rule of 1031 exchanges? This rule allows an investor to identify up to, but not more than, three potential like-kind replacement properties. Exeterco.com reports:

In the event an Investor needs to identify more than three (3) potential like-kind replacement properties he would ignore the three (3) property rule and look exclusively to the 200% rule which is described next. With the three (3) property rule, there is no limitation on the market value of the identified potential like-kind replacement properties. The limitation is only on the total number of potential like-kind replacement properties the Investor can identify. Although he could do so, the Investor is certainly not required to acquire all of the like-kind replacement properties identified.

Read more: Introduction to Tax-Deferred Like-Kind Exchanges

Can All Property Be Exchanged Under 1031?

Does any and every property qualify for a 1031 exchange? If that were the case, your personal residence and vacation home could have qualified. However, only property that has been or will be held for income production (rental), investment or used in a trade or business can be used for a 1031 exchange. Transunionexchange.com reports:

It is important to consult with your legal and tax advisor to determine whether your property will satisfy the qualified use and like-kind tests, especially in the areas of personal property 1031 exchange transactions.

Read more: 1031 Tax Deferred, Like-Kind Exchange

Is Your Intermediary Qualified?

--By Priya Jestin, Staff Writer

One important requirement in a 1031 exchange is that of a ‘qualified intermediary’. This intermediary is supposed to facilitate the exchange process, which includes the creation of an escrow account for the sale of the relinquished property. S/he is also supposed to file the essential documents.

I will provide you with the exact IRS definition of the term so you can understand it better. According to the IRS, A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. The wording of this contract is extremely critical. Your contract to sell or purchase real estate must contain wording that shows your intent to perform a 1031 exchange.

Since the qualified intermediary is such an important component of a 1031 exchange, if you want to go in for such a transaction, ensure that you have a good intermediary. For this purpose, you must not try to do business with the first intermediary you come across. You should compare the services, costs, and references of several qualified intermediaries before selecting one to handle your 1031 exchange. This is extremely essential since the work they do is essential to the success of the exchange. So, you must make sure that your qualified intermediary is a trustworthy and experienced company or individual.

Before you finally decide on an intermediary, you should ask as many questions as necessary. By the time you are ready to conduct your 1031 exchange, you should be comfortable with the entire process and it is your qualified intermediary who should ensure this. If you are not satisfied with his/her answers or if they try to avoid any questions you ask, dump the intermediary and look for another one. A tax-deferred exchange is not difficult to do, but there are specific steps you must follow to make sure every aspect of the sale and purchase complies with US tax laws and it is your qualified intermediary who ensures that the process goes smoothly.

Do You Qualify?

--By Priya Jestin, Staff Writer

Fine you are interested in a 1031 exchange and know a bit about it. What you are essentially doing with a 1031 exchange is deferring your taxes until a later date. But there are certain rules that you need to follow in order to qualify. One of the first things is that the property you are giving away, and the property you have found as replacement, must be held either for investment or for productive use in a trade or business. You cannot exchange a personal residence.

Remember, the asset must be of like kind that is you should be able to exchange real property for real property and not intellectual property or any other type of property. Another thing you should keep in mind is that you must invest the proceeds of the sale in a like kind asset within 180 days of the sale. And you should have identified the property within 45 days.

Did You Know?

-- By Pushpa Sathish, Staff Writer

That rules governing 1031 exchanges extend to property outside the United States too? The only catch is that you have to exchange property outside the country for like-kind property that is also located outside the US in order to defer capital gains taxes.

Save on a 1031 Exchange

-- By Pushpa Sathish, Staff Writer

A 1031 exchange results only in the deferral or postponement of capital gains taxes; it does not remove them from the picture altogether. But there are a few ways the deferral can be converted to savings.

• If the replacement property that is initially purchased for the purpose of investment converted to a personal home at a later date, the exchanger is eligible for a tax discount under Section 121. If he/she is married, the couple saves $500,000; an individual saves as much as $250,000. The only condition is that the property in question should not have been involved in a 1031 exchange for the past five years.
• In the event of the death of the exchanger, his/her heirs can, according to inheritance laws at the time of death, claim the estate free of tax. Current inheritance laws stand at $2,000,000 for an individual.

The Importance of Form 4868

-- By Pushpa Sathish, Staff Writer

In certain 1031 exchanges, the 180-day deadline for the purchase of the replacement property and the closure of the exchange may fall in the tax year after the one in which the relinquished property was sold. In such cases, the exchanger has to file the necessary tax forms to ensure that the exchange qualifies for a tax deferral. Filing the Form 4868 Application for Extension to File Tax Return will make your exchange be treated as a taxable sale made on an installment basis.

If the exchanger closes the exchange within the mandated 180 days, he defers his capital gains taxes. Otherwise, he is considered to have under-reported his income for the year in which he sold his relinquished property, and thus liable to interest and penalties. 

What is the Napkin Rule?

-- By Pushpa Sathish, Staff Writer

If you come across the word “napkin” being used in conjunction with a 1031 exchange, don’t look surprised. The Napkin Rule is just another fancy name for the rule that mandates that your replacement property must equal to or greater in value than your relinquished property for you to completely postpone payment of capital gains taxes. You are also required to use all the proceeds from the sale of your relinquished property for the purchase of the replacement property. If you hold back some of the sale money, you will be liable to pay tax on the amount.

Tax Forms For 1031

-- By Pushpa Sathish, Staff Writer

There are various tax forms that need to be filled out during the process of a 1031 exchange. For the layman with little or no knowledge of tax-related formalities and terms, there are always CPAs and Tax Advisors willing to help out.

Three commonly used forms are:

http://www.irs.gov/pub/irs-pdf/f8824.pdf
http://www.irs.gov/pub/irs-pdf/f4562.pdf
http://www.irs.gov/pub/irs-pdf/f4797.pdf