WHAT IS A 1031 NON-SIMULTANEOUS TAX DEFERRED EXCHANGE? 

Section 11031 of the Internal Revenue Code allows a taxpayer to defer the capital gains tax normally due on the sale of property held for investment or used in a business or trade by exchanging for other like-kind investment or business property. This permits the taxpayer to sell property and reserve the right to exchange for other investment property of equal or greater value, as long as the new property is identified and the purchase closed within the time limits set forth in the code. 

WHY EXCHANGE? 

Leverage
Funds that would have gone to pay capital gains tax may be used to acquire additional or more valuable properties 

Defer taxes
The exchanger can exchange into a different investment property and defer the tax liability 

Estate Planning
Taxes deferred in an exchange are “forgiven” upon the death of the taxpayer and the basis is stepped up to current market value 

Cost-saving Investment Management
Exchange passive investment such as land for income-
producing property such as apartments OR exchange
income producing property for a passive investment and reduce management without incurring an immediate tax liability 

Retirement Planning
Exchange a large limited-use property and acquire several smaller, more marketable properties that can be readily sold when funds are needed for retirement

PROPERTY RULES

Like-Kind rule: The property being Relinquished and
the Replacement Property must be used in productive trade or business or be held for investment. Real property must be exchanged for real property; although personal property can be exchanged for personal property, the two types cannot be mixed in the same exchange without tax consequences.  

3 Property Rule: The Exchanger may identify three
properties of any value as Replacement property; 

OR 

200% Rule: The Exchanger may identify more than
3 properties if the total fair market value of
what is identified does not exceed 200% of
the sale price of the Relinquished Property.
The value of each must be stated on the identification form; 

OR 

95% Rule: If the Exchanger violeate either of the
above rules, the Exchange may still be valid if the Exchanger acquires 95% of the fair market value of what was identified. 

Some examples of ineligible property: 

Primary residences
Foreign real property
Securities or notes
Inventory
Vacation homes
Stocks and bonds 

SECTION 1031 TAX-DEFERRED LIKE-KIND EXCHANGE 

The elimination of preferred tax treatment for capital gains has left investors with few options for preserving and building their real estate wealth. The Tax-Deferred Like-Kind Exchange may be the best alternative available.  

Section 1031 of the Internal Revenue Code allows exchangers to defer (postpone) payment of taxes on gains from disposal of real property, if such property exchanged is for “Like-Kind” property. The properties disposed of and acquired must be held for investment or the productive use in a trade or business.  

The owner of property that has substantially appreciated in value has at least seven alternatives: 

1. Continue to hold the property. 

2. Refinance the property and use the cash. 

3. Sell the property and pay the capital gains tax. Reinvest the proceeds. 

4. Sell the property on an installment sale and pay the capital gains tax over the term. 

5. Utilize a Charitable Trust. 

6. Utilize a Bargain Sale. 

7. Complete a Section 1031 Like-Kind Exchange.  

THE INTERNAL REVENUE CODE SECTION 1031 

“IRC Section 1031 (a) exchange of property held for productive use or investment.  

No gain or loss shall be recognized if property held for productive use in trade or business or for investment (not including stock in trade or property held primarily for sale, nor stocks, bonds, notes, partnership interests, certificates of trust or beneficial interest or other securities or evidences of indebtedness or interest) is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment.” 

LIKE-KIND PROPERTY 

“Like-Kind” means that property held for investment must be exchanged for property held for investment. The” Like-Kind” requirement does not mean you must exchange unimproved property for unimproved property or improved property for improved property.  

In addition to the “Like-Kind” requirements, there are economic criteria to consider in achieving a fully tax-deferred exchange:  

ALL NET PROCEEDS INVESTED IN REPLACEMENT PROPERTY
TRADE EVEN OR UP IN VALUE
TRADE EVEN OR UP IN MORTGAGE 

This means one should acquire a “target” property that is more expensive and has a larger mortgage than the property one is disposing of and all of the cash proceeds from the first property should be invested in that target property. 

SIMULTANEOUS EXCHANGES 

A tax-deferred exchange can be completed simultaneously, that is, all of the properties being exchanged are closed at the same time in an interdependent escrow. 

In a Simultaneous Exchange, the client disposes of their property at the same time he or she acquires the “target” property. 

Frequently, exchanged property buyers or target property sellers are reluctant to participate in a Simultaneous Exchange because they may have to incur unwanted contractual risks and liabilities. A major concern is the potential liability for hazardous waste on property momentarily acquired only to accommodate an exchange.  

DELAYED EXCHANGES 

If a Simultaneous Exchange is not possible, because the target property has not been located, Facilitators can preserve your 1031 benefits with a Delayed Exchange.  

Prior to 1984, the IRS regularly challenged Delayed “Starker” Exchanges. Congress has changed the law to specifically authorize Delayed Exchanges, but also set these specific deadlines for their completion: 

The target property must be “identified and designated” on or before 45 days from the closing of the first sale.  

The “identified and designated” target property must be acquired (by the exchanger) on or before 180 days from the first sale OR the due date for the tax return for the year of the sale, whichever comes first. Get an IRS extension. If a corporation, know when the fiscal year ends. 

Delayed Exchanges have become more prevalent and popular since authorized by law, but proper documentation is very critical.
The regulations provide two safe harbors on the number of properties you can identify and designate: 

ALTERNATIVE AND MULTIPLE PROPERTIES 

There are limitations on how many replacement properties one may identify in the same deferred exchange, no matter how many relinquished properties one transfers. 

One may identify more than one property as replacement property subject to two rules: the 3-Property Rule and the 200% rule. Only one of these rules has to be satisfied, not both. 

THE 3-PROPERTY RULE 

The maximum number of replacement properties one may identify is three properties without regard to the fair market values of the properties.  

THE 200-PERCENT RULE 

One may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all the relinquished properties. You figure the fair market value of the replacement property as of the end of the identification period. Figure the fair market value of the relinquished properties as of the date ownership is transferred. 

If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no replacement property has been identified. However, there are two important exceptions to this rule: 

1. It does not apply to any replacement property received before the end of the identification period, and
2. It does not apply to any replacement property identified before the3 end of the identification period and received before the end of the exchange period. However, to qualify for this excepti0on you must receive identified replacement property constituting at lease 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period. 

CAUTION: Section 1031 is a rapidly developing area of law. The information contained should be reviewed with the exchanger’s tax and/or legal advisor(s) to verify that changes in tax law; IRS regulations and court decisions have not affected its applicability.

I.R.C. SECTION 1031
TARGET PROPERTY IMPROVEMENTS 

An exchanger may want to rehabilitate or construct improvements on a Target Property in order to increase its value to match the Exchange Property. This may happen when the ideal replacement property requires fewer funds than are being held in the exchange accounts and the Exchanger would like to invest remaining funds in improvements.  

Another circumstance may be that there is no property on the market, which exactly matches Exchanger’s needs. In this case, the Exchanger may identify replacement property, which is not yet built but will be completed during the exchange period. 

This may present problems given the time constraints of a delayed exchange. Any improvements paid for with exchange funds must be completed within 180 days of the closing on the Exchange Property and before the transfer of the Target Property to the Exchanger and it is possible to structure the transaction so the overall improvements need not be completed.  

The acquisition of the Target Property by the Exchanger can be viewed as a “snapshot” which freezes the funds in the exchange account. Funds left in the exchange account after the “snapshot” closing date no longer can qualify for tax-deferral, even if the funds are spent to improve the Target Property after closing. 

The best practice is to convince the Target Property Seller to construct the improvements within the 180-day period with his own funds and raise the sales price of the Target Property. If the seller is reluctant to use his own money, the Facilitator may advance the Seller the required funds through secured loans out of the exchange funds. 

If the Seller is unwilling to construct improvements on the Target Property, the Facilitator may acquire the Target Property and then construct the improvements with exchange funds prior to transferring the Target Property to the Exchanger. This may trigger a dual excise tax in the state of Washington.  

Careful structuring of this arrangement is essential. Any construction contracts must be between the Facilitator and the contractors. Bills for the improvements must be made out in the name of and paid by the Facilitator. 

CHARITABLE REMAINDER TRUST 

The Charitable Remainder Trust is the most common form of estate planning trust to secure income for life or a certain period of years, save taxes, pass assets to family members, and gift to charity. 

Charitable trusts are beneficial if one owns highly appreciated property, is in a high tax bracket and would like to enjoy their profits now. This can be accomplished and avoid capital gains tax, estate taxes and provide a gift to charity.  

The client transfers the asset into an irrevocable trust with trustee and names a qualified charity as remainder man. The trustee sells the property at fair market value, without paying capital gains tax, and re-invests the proceeds into income producing assets. The trust pays the client or their heirs income for life or a certain period of years and upon termination, the remaining trust assets go to the charity of client’s choice.