What is a 1031 Exchange?
Click on a link below to see the form or checklist in PDF format.
- Deposit, Receipt, Offer, and Acceptance (DROA): Intake Checklist
- Real Estate Exchange (1031): Checklist
- Deed: Checklist
Basic Requirements for 1031 Exchange
A Section 1031 exchange allows you to exchange certain property interests for interests of "like kind" without having to pay capital gains tax on the exchange. Since you have real property owned in fee simple to exchange, the replacement property "like kind" property would be fee simple (and certain long term leasehold real property). The replacement property must either be acquired for trade or business purposes or for investment purposes. The replacement property cannot be acquired for personal use purposes (your personal residence) or for resale (inventory). Because real estate is involved, your replacement property can be improved or unimproved real estate. The improvements can range from residential structures, fee simple condominium apartments, to commercial or industrial structures.
The basic idea in a 1031 exchange is to defer the recognition of taxable gain because you are exchanging property. This does not work if you are not exchanging like kind property. If you receive cash from the transaction, you are obviously not exchanging property since you are receiving money. Section 1031 therefore provides that when you receive (or have the right to receive) cash, that you will be deemed to receive "boot" and be taxable up to the lesser of either the boot received or the total capital gain on the transfer. Property which is not "like kind" will also be "boot". In a real estate exchange, personal property items such as furniture will be boot as to the real estate. Mortgage relief will also be included in "boot". For mortgage relief boot (but not for cash boot), it is possible to offset the boot by either assuming mortgage on the replacement property or by acquiring more replacement property than the amount of exchange proceeds.
Deferred Section 1031 Exchange
Although a simultaneous exchange is possible, most exchanges are done using an exchange intermediary ("exchange company") so that the first part of the exchange can close without waiting for the replacement property to be acquired. The intermediary is substituted for the owner so that the exchange company actually deeds the property to the first buyer. The exchange company is paid the money from the sale and holds that money until the owner finds suitable replacement property and signs a DROA to buy that property. At that point, the exchange company is substituted so that it buys the replacement property with the funds it is holding.
There are now detailed IRS rules that describe how deferred 1031 exchanges must work. Using an exchange company is probably the easiest way of complying. Because the exchange company will be holding large sums of money and your only rights against the company are under the exchange agreement, I prefer dealing with an exchange company that is associated with an escrow company. It is possible to structure some forms of security with respect to the exchange transaction, but that would involve special documentation and the cost of setting those up will probably more than offset the savings in using non-escrow related companies. You may choose any exchange intermediary you find is suitable.
One variation in a deferred exchange is to "direct deed" the exchange and replacement properties; i.e., you would convey directly to the buyer of the exchange property and would receive title directly from the owner of the replacement property. The advantage is that you can avoid the second conveyance tax on both the exchange property and the replacement property. Since the IRS regulations are very specific on qualifying direct deed transactions, we need to be careful about the wording and mechanics of direct deed transactions. There is more leeway if the title is passed through the exchange company and I was reluctant to use direct deeding, but the conveyance tax cost is a factor so unless you direct otherwise, I will set up the exchange for direct deeding.
Deferred exchanges involve two deadlines with which you must comply. The first is the 45-day deadline in which you must identify the replacement property. The identification is made to the exchange company and must be in writing signed by the taxpayer. You may identify more than one property and if you are not sure that you can get a property, you may identify alternate properties. However, under the IRS rules, if you identify more than three properties, there are some calculations that need to be made to be sure that you do not disqualify the identification. The 45 days run from the time that the exchange property closes.
The second deadline is a bit trickier. You will have the shorter of 180 days or the time when you timely file your 1999 Federal income tax return in which to close the purchase of the replacement property. If you need the additional time to complete the acquisition (past April 15, 2000), you must apply for the 4-month automatic extension for filing your Federal income tax return (Form 1040) even if you could otherwise file the return. By doing so, you will have up to the 180-day limit to acquire the replacement property. The acquisition period starts as of the closing of the exchange property and not at the end of the 45-day period.
There are no extensions on either of these two deadlines, so you must be sure to comply.
Tax Basis and Gain/Loss Realized
You should determine your tax basis in the exchange property. The potential gain (or loss) on the exchange is the difference between the sales price of the exchange property (less selling expenses) and the tax basis. If Section 1031 applies, that gain or loss is not recognized unless there is "boot". If "boot" exists, then a portion of the gain or loss will be recognized. If the "boot" is cash, the gain or loss will be recognized to the extent of the cash. If "boot" is mortgage relief, the gain or loss will be recognized up to the "net boot" amount. When you do a 1031 exchange, your tax basis in the replacement property will be the same as your basis in the exchange property plus an amount equal to additional payments made to acquire the replacement property and amount of mortgage assumed. This means that you may have little or no depreciation on the replacement property since you cannot take depreciation in excess of your tax basis.
Cost of Exchange
The exchange company will charge you a fee for services. The typical fees involve a minimum charge which may be increased by a percentage of the exchange property sales price. There is usually an additional charge if more than one replacement property is involved and there may be a monthly charge for each month that the exchange remains open. The exchange company should have a schedule showing those fees. The typical charges for a single exchange property and single replacement property would be about $500. In addition, the company may keep all of the interest earned on your funds.