What is like-kind property?
In the context of a 1031 exchange, any property which has been held for productive use in a trade or business or for investment purposes can be exchanged for real property to be held for similar purposes. Domestic property can only be exchanged for other domestic property. Foreign property for foreign property. A persons’ primary residence, second home (unless rented out for a season) or property held primarily for resale (dealer) are excluded from doing an exchange Like-kind property can include, but is not limited to the following, provided it is held for investment:
- Single Family Rental
- Industrial Building
- Commercial Property
- Raw Land
- Fee interest in property for leasehold with 30 or more years to run
Therefore, a single family dwelling, if held for investment, can be exchanged for raw land.
Personal property that qualifies for 1301 exchange treatment can only be exchanged within the same General Asset Class or within the same Product Class. The North American General Asset Class Classification System provides categories for General Asset Classes of depreciable tangible personal property. It is critical to review any personal property transactions with tax advisors because the rules are more restrictive than for real property.
Why an Exchange and not a Sale
The benefits of a 1031 Exchange can be tremendous. Investors can defer thousands of dollars in capital gain taxes both on a federal and state level. If the procedures for an exchange are followed, capital gain recognition will be deferred until the investor chooses to recognize it.
Also, doing an exchange allows the investor to invest all the proceeds from the sale rather than the net amount after taxes are paid which increases the purchasing power and thereby increasing the investor’s portfolio of wealth.
Some of the advantages of an exchange are preservation of equity, maximize return on investment, increased cash flow from larger properties, change in the type of property held, being able to take your investment property with you when you move without paying taxes.
What Language Should be Added to the Contract in an Exchange
The Internal Revenue Code requires that there is language in both the sale and purchase contracts establishing the investor’s (ERI) intent to perform an exchange. It is important that both contracts are assignable. In order to structure a typical exchange transaction, ERI must be assigned in as the seller of the relinquished property and also as the buyer of the replacement property.
The statement below, which we suggest be included in the sale and purchase contracts, establishes the investor’s intent to perform a tax deferred exchange and releases the other parties from costs or liabilities as a result of the exchange.
Sale of Relinquished Property
“Buyer hereby acknowledges that it is the intent of the seller to affect a 1031 exchange. The seller’s rights and obligations under this agreement will be assigned to Exchange Resources, Inc. for the purpose of completing an exchange. Buyer agrees to cooperate at no additional cost or liability with seller and Exchange Resources, Inc. in a manner necessary to complete the exchange.”
Purchase of Replacement Property
“Seller hereby acknowledges that it is the intent of buyer to affect a 1031 Exchange. The buyer’s rights and obligations under this agreement will be assigned to Exchange Resources, Inc. for the purpose of completing an exchange. Seller agrees to cooperate at no additional cost or liability with buyer and Exchange Resources, Inc. in a manner necessary to complete exchange.”
When must an exchange be opened with Exchange Resources, Inc.
Paperwork must be completed prior to the close of the sale property. Last minute exchanges are possible, even on the day of closing, but only if we are brought into the transaction prior to the actual closing.
Why a Qualified Intermediary?
In most circumstances, the use of a “Qualified Intermediary” (QI) is required to successfully complete an exchange. Sometimes a QI is referred to as an accommodator, straw person or third party facilitator. A QI is an entity which is not the investor or a disqualified person which enters into a written agreement with the investor (exchange agreement) under which the QI acquires the sale property from the investor, transfers the sale property, acquires the purchase property and transfers it to the investor.
The use of an experienced QI can significantly reduce the complexity of an exchange by assuring the proper execution of required documentation. The careful selection of a QI is essential to secure the highest levels of expertise and security of funds.
Exchange Resources, Inc. prepares the necessary exchange documentation and works with the investor’s closing agent, attorney and accountant as needed to insure that the rules and regulations are thoroughly understood and followed. ERI facilitates the transfer of the sale property and the purchase of the replacement property. ERI holds and protects exchange proceeds on behalf of the investor. ERI provides guidance, information and awareness of critical timelines throughout the entire exchange.
Access to Your Exchange Funds
The IRS Regulations and Rulings expressly limits the investor’s rights to receive, pledge, borrow or otherwise obtain benefits of money or other property held by the QI during the course of the exchange. The IRS prohibits the actual or constructive receipt of exchange funds during the exchange period. However, access to exchange funds can be obtained when the investor has met one of the following conditions:
- The 45 calendar day identification period has expired and no replacement property was identified; or
- The investor has purchased all of the properties identified and the 45 day identification period has expired; or
- The 180 calendar day exchange period has expired.
Does it Matter How I Hold Title from the Sale to the Purchase Property?
To have a valid exchange, it is important that taxpayer who transferred the relinquished property be the same who buys replacement property. Typically, the Qualified Intermediary will reflect the names in the exchange agreement as vested in the title report or title commitment on the relinquish property.
Do I need to Buy Equal or Greater to the Sales Price to have a Good Exchange?
Yes, the general rule to defer all capital gains on an exchange is for the investor to exchange of equal or greater value. To be exact, the investor needs to reinvest all the net proceeds into the replacement property and to obtain an equal or greater new debt on the replacement property or add equivalent cash to offset the debt relief on the relinquished property.
If the investor buys for less, the exchange is still valid but there will be a taxable event on the difference. This difference is called “boot” which is taxable.