PURPOSE: Defer payment of capital gains taxes.
PROPERTY THAT CAN BE EXCHANGED: Real property or personal property such as aircraft, vessels, equipment, or art.
LIKE KIND REQUIREMENT: Properties must be like kind. For example, real estate for real estate or aircraft for aircraft.
INVESTMENT REQUIREMENT: Properties must be held for investment or in connection with a trade or business but do not have to be similar use (exchange raw land for an apartment building).
EXCHANGE TRANSACTION: This has two parts. The transfer of relinquished property and acquisition of a replacement property.
SAME TAXPAYER REQUIREMENT: The taxpayer must acquire title to the replacement property in the same manner as title was held to the relinquished property. The only potential exception is a single member limited liability company of which the taxpayer is the sole member.
DEADLINES: Two deadlines, both of which begin on the date of transfer of the first relinquished property. Replacement property (or properties) must be identified within 45 days. The exchange must be completed by the earlier of 1) 180 days from the date of the first relinquished property closing; and 2) the due date of the taxpayerís federal income tax return, together with all extensions.
IDENTIFICATION RULES: Two identification rules from which to choose – 1) 3 Property Rule- up to three (3) properties can be identified without regard to their fair market value. 2) 200% Rule- Any number of properties as long as their combined fair market value does not exceed 200% of the fair market value of all relinquished property.
FULLY DEFERRED EXCHANGE: Must meet three (3) criteria to have a fully deferred exchange. 1) The replacement property (or properties) must be equal to or greater in value than the value of the relinquished property; 2) the amount of equity in the replacement property (or properties) must be equal to or greater than the amount of equity in the relinquished property; and 3) the taxpayer cannot receive any non-like kind property such as cash from the sale fo the relinquished property or taking back a Promissory Note from the buyer of the relinquished property. To the extent all three (3) criteria are not met, tax consequences are created.
Actual Title will work with First American Exchange Company to facilitate your 1031 exchange. Below Is a Step-by-step Delayed Exchange Procedure through First American Exchange Company.
- Taxpayer (also called “Exchangor“) enters into an agreement to sell a business or investment property.
- Taxpayer retains the services of an independent tax advisor.
- To avoid paying costly capital gains taxes, Taxpayer requests that First American Exchange Company act as Qualified Intermediary in the property sale. Taxpayer then completes the Relinquished Property Information Form and returns it to First American Exchange Company along with a copy of the purchase and sale agreement.
- Once all contingencies under the purchase and sale agreement are satisfied, and at or before the closing of the transfer of the relinquished property, Taxpayer enters into an Exchange Agreement and assigns the purchase and sale agreement to First American Exchange Company as “intermediary“, causing the company to be substituted in his stead as “seller”.
- Intermediary issues escrow closing instructions directing that Taxpayer will be shown as “grantor transferor” on a direct deed to the buyer of the relinquished property.
- The first half of the exchange closes with the transfer of the relinquished property – the time periods begin to run.
- First American Exchange Company as intermediary deposits the net proceeds from the sale of the relinquished property into an interest-bearing qualified escrow account. Taxpayer is entitled to receive a “growth factor” from the intermediary in the same amount as the earnings on the net proceeds received by intermediary during the exchange.
- First American Exchange Company confirms receipt of the funds to Taxpayer, informs Taxpayer of his/her deadlines under the exchange and provides an identification notice form for Taxpayer’s use in identifying replacement property (or properties).
- Taxpayer identifies replacement property (or properties) by signing and forwarding the identification notice to intermediary on or before the 45th day after the transfer of the relinquished property.
- Taxpayer enters into an agreement to purchase the replacement property.
- Once all contingencies under the purchase agreement are satisfied, and at or before the closing of the acquisition of the replacement property, Taxpayer assigns the purchase agreement to intermediary causing intermediary to be substituted in his stead as the buyer of the replacement property.
- Intermediary issues escrow/closing instructions directing that Taxpayer will be shown as grantee/ transferee on a direct deed from the seller of the replacement property.
- The final portion of the exchange closes concurrently with acquisition of the replacement property (or in stages if multiple replacement properties are involved), all on or before the 180th day after transfer of the relinquished property or the due date (including extensions) of Taxpayer’s tax return, whichever is earlier.
- Intermediary provides Taxpayer with a statement showing all activity on his account.
- Taxpayer files Form 8624 with the IRS (and, depending on state law, equivalent documentation with state tax authorities).
“Basis” -the value invested in property for tax purposes. Calculation: original cost, plus improvements, minus depreciation taken.
“Boot” – non-qualified (non “like kind”) property received in an exchange. (Examples: cash, promissory notes, furniture, reduction in debt obligations.)
“Constructive Receipt” – control of proceeds by the Taxpayer (even though funds may not directly be in the Taxpayer’s possession).
“Deferred Exchange” or “Delayed Exchange” – an exchange qualifying for non-recognition treatment under Section 1031 of the Internal Revenue Code where there is a gap in time between the transfer of the relinquished property and the receipt of the replacement property.
“Direct Deeding” -deeding of the relinquished property from the Taxpayer directly to the buyer, or the replacement property from the seller directly to the Taxpayer, without passing title through the intermediary.
“Disqualified Person” – a related person (determined under income tax regulations) or agent of the Taxpayer (including an attorney, accountant, real estate agent, or investment banker). A Disqualified Person may not act as the Taxpayer’s intermediary in an exchange.
“Exchange Accommodation Titleholder” -person or entity other than the Taxpayer or a Disqualified Person that agrees to take title to either the Taxpayer’s relinquished or replacement property until such time as the Taxpayer is able to sell the relinquished property to a third-party buyer.
“Exchange Period” – the period during which the Taxpayer must acquire his/her replacement property. It begins on the day in which the relinquished property is transferred and ends at midnight on the 180th day thereafter or the due date (including extensions) of Taxpayer’s tax return, whichever is earlier.
“Identification Period” – the period during which the Taxpayer must identify higher replacement property. It begins on the day in which the relinquished property is transferred and ends at midnight on the 45th day thereafter.
“Intermediary” or “Qualified Intermediary (QI)” – a person or entity that facilitates the exchange for the Taxpayer.
“Like Kind Property” – refers to the nature or character of the property, and not its grade or quality. Generally, real property is “like kind” lo 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. The “like kind” rules for personal property, however, are much more restrictive.
“Relinquished Property” – the property that is transferred by the Taxpayer in an exchange.
“Replacement Property” – the property that is acquired by the Taxpayer in an exchange.
“Taxpayer” or “Exchanger” -the person who is seeking to defer capital gains tax through a Section 1031 exchange.