Investment Property Only
Tax-deferred exchanges are available only for investment property. Primary residences do not qualify for exchanges. The universal exclusion, under §121 of the Internal Revenue Code, permits the elimination of capital gains from the sale of primary residences. If a portion of a primary residence is used for investment pur- poses, that portion may be exchanged.
Finding the Right Replacement Value
In general, the value of the replacement proper- ty should be equal to or greater than the sales price of the relinquished property, not the net proceeds received. The IRS permits the deduction of commissions and non-recurring closing costs associated with the sale of the relinquished property in determining the replacement property value. To defer all the capital gains incurred for the sale of the relinquished property, the investor must:
- Use all of the cash proceeds from the sale of the relinquished property; and
- Replace any debt associated with the relinquished property. This can be accomplished by replacing the debt with cash, taking the property subject to the existing debt or by obtaining new financing, including a seller carry-back.
Cash and Debt Boot
Any cash proceeds remaining after the acquisi- tion of replacement property are considered “cash boot” and are taxable at the capital gains rate. Access to these funds is limited in accordance with IRS restrictions. If debt is not replaced it is considered “mortgage boot,” which also incurs tax liability to the investor at the capital gains rate. As each investor’s financial situation varies, it is recommended that the investor consult their accountant or experienced tax attorney before opening an exchange.
The opposite party in an exchange must be notified of the intent of the buyer or seller to effectuate an exchange. The following is sample verbiage that may be inserted into the purchase or sale contract to comply with this requirement.
“[Buyer/Seller] hereby acknowledges that it is the intent of the [Buyer/Seller] to affect a §1031 tax-deferred exchange. The [Buyer’s/ Seller’s] rights and obligations under this agreement are hereby assigned to Exchange Resources, Inc. for the purpose of complet- ing a §1031 exchange. [Buyer/Seller] agrees to cooperate, at no additional cost or liability, with [Buyer/Seller] and Exchange Resources, Inc. in a manner necessary to complete the exchange.”
The IRS requires the same tax entity that initiat- ed the exchange be the same entity concluding the exchange. Accordingly, the replacement property is to be vested in the same manner as the vesting of the relinquished property when sold. The Qualified Intermediary reflects the names in the exchange agreement as those found in the vesting of the title report for the relinquished property.
Please note: The following changes in vesting during the course of the exchange generally do not affect the validity of the exchange. It is strongly recommended that the investor consult with their accountant or tax attorney regarding their specific circumstances to ensure compliance.
- An investor selling the relinquished property held in the investor’s revocable trust and acquiring the replacement property held in the name of the investor as an individual.
- An investor selling the relinquished property as an individual and acquiring the replacement property in a single member LLC.
- An investor selling the relinquished property as an individual and the investor’s estate acquiring the replacement property because the investor deceases prior to the completion of the exchange.
Tenancy In Common (“TIC”) Interests
Investors are permitted to pool their assets with other investors in the acquisition of like-kind replacement property. Many investors prefer TIC investments for the financial security and minimal maintenance such an agreement may provide. However, the individual investor must ensure their corresponding interest is sufficient to defer all of the capital gains tax associated with the sale of the relinquished property.
Partnerships are permitted to exchange as long as the exchange is completed at the partnership level. Extremely complex tax issues arise when the underlying partners each have different investment goals and elect to separate or restructure. Consultation with a tax professional is critical to ensure the anticipated tax benefits are received by the partnership.
The IRS prohibits the actual or constructive receipt of exchange funds during the exchange period. Receipt of such funds is limited to stringent circumstances. For example, funds held by the Qualified Intermediary may be released, but only after the 45-day identification period, if no identification of replacement property has been made or all of the replacement property that was identified has been purchased. The earliest possible date at which exchange funds are available to the investor is the 46th day following the transfer of the relinquished property.
The IRS permits partial exchanges. An investor may use a portion of the net proceeds from the relinquished property to purchase the identified replacement property and exclude a portion of the net proceeds for their personal use.
However, these funds are considered cash boot and consequently taxable at the capital gains rate and may be subject to withholding. The investor must inform ERI before the close of escrow on the relinquished property if they wish to exclude cash or the investor may have to wait until the end of exchange period for access to the remaining funds.
It is recommended that the investor consult their accountant or tax attorney to determine if it is advantageous to effectuate a partial exchange.