Frequently Asked Questions
Everything you need to know and more.
What is a Qualified Intermediary?
A Qualified Intermediary is NOT permitted to be someone who has been your employee, attorney, accountant, investment banker, broker, or attorney during the 2 years prior to the transfer of your Relinquished Property.
How to spot a great Qualified Intermediary?
An experienced Qualified Intermediary should ensure the highest level of transparency and security of funds. They should also possess the following characteristics:
- Member of the FEA (Federation of Exchange Accommodators)
- Certified Exchange Specialists® on staff
- In-house attorneys on staff
- Fidelity Bonding
- Errors & Omissions Insurance
- Provide a separate client trust account for each exchange
- Over 20 years in business
What does Like-Kind Mean?
Examples of like-kind real property:
- Vacant Land
- SFH (Single Family Home)
- Condominiums and Townhomes
- Commercial Property (Retail, Industrial, Office, Multifamily)
- Oil and Gas Rights
- Co-ops (30+ Year Leasehold Interest)
- Delaware Statutory Trust (DST)
- Fee Simple Tenant-in-Common Interests (TIC)
For example, if you sell a commercial building you are permitted to purchase a townhome as your like-kind replacement property in the exchange.
Do I need specific contract language?
You are required to notify the opposite party in your sale or purchase of your exchange. This is most easily accomplished by including the following language in your contract:
Relinquished Property Language – “Buyer hereby acknowledges that it is the intent of the Seller to affect a §1031 tax-deferred exchange. The Seller’s rights (but not obligations) under this agreement are hereby assigned to Exchange Resources, Inc. for the purpose of completing a §1031 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.”
Replacement Property Language – “Seller hereby acknowledges that it is the intent of the Buyer to affect a §1031 tax-deferred exchange. The Buyer’s rights (but not obligations) under this agreement are hereby assigned to Exchange Resources, Inc. for the purpose of completing a §1031 exchange. Seller agrees to cooperate, at no additional cost or liability, with Buyer and Exchange Resources, Inc. in a manner necessary to complete the exchange.”
Remember, the exchange must also be opened prior closing escrow.
What is Boot?
Cash Boot – Any proceeds remaining after the acquisition of the replacement property are taxable at the appropriate capital gain rate.
Mortgage Boot – Any debt from the relinquished property not replaced by cash or new debt on the replacement property.
If the relinquished property is located in California, it is important to note that The California Franchise Tax Board now requires QI’s to withhold 3 1/3% of all boot, including mortgage boot.
How do you calculate the reinvestment value of your 1031 Exchange?
To defer all capital gain associated with your sale of the Relinquished Property you must meet or exceed the replacement value in your exchange. To determine the replacement value the IRS permits you to deduct the amounts paid for non-recurring closing costs associated with the sale of the Relinquished Property contract price.
Non-recurring Closing Costs:
These closing costs may be deducted from your sale price as the first step to reaching your target number:
- Notary/Recording Fees
- Brokerage Commissions
- Tax Advisor Fees
- Transfer Taxes City/County
- Attorney Fees
- Inspection Fees
- 1031 QI Fees
- Referral Fees
- Escrow Processing Fees
- Contractual Conditions of Sale
- Title Insurance on the Sale
For full tax deferral you are also required to use the entire net sale proceeds from the Relinquished Property and replace any debt that was paid off when the Relinquished Property was sold. Using your closing statements locate the amount of loan which was paid off at the time of sale. This will be your new minimum loan value if you wish to fully defer your taxes. If you wish to decrease the size of the loan on your new property you will be allowed to bring in new cash as a substitute.
Formula: Sale Price – Non-Recurring Closing Costs = Estimated Replacement Value
What kind of property does not qualify?
Personal Property – The 2018 Tax Cuts & Jobs Act limited exchanges to real property exclusively. Machinery, equipment, artwork, and vehicles, among other personal property assets are no longer exchangeable.
Primary Residence – The 121 Exclusion provides capital gains tax exclusion benefits upon the sale of primary residences if resided in at least 2 of the last 5 years. Single taxpayers can exclude $250k and married couples filing jointly can exclude $500k of the gain.
REIT – A Real Estate Investment Trust (REIT) is a company that owns and collects rents on the property held in its portfolio and the income generated is distributed as dividends to the shareholders. The individual shares are considered personal property and do not qualify for an exchange.
Inventory (Property held primarily for sale, generally “flips”)
Certificates of Trust
What is considered “real property” and what is considered “personal property”?
Under current QI safe harbors rules, a QI may not use exchange funds for anything other than real property or non-recurring closing costs. The penalty for using funds otherwise can be the disallowance of the entire exchange.
Machinery that does not serve the basic function of the building is not considered real property. Under the proposed regulations, each asset must be examined separately to determine if it is real property. Assets other than land are divided between inherently permanent structures and their structural components.
Inherently permanent structures: Real property includes typical structures such as buildings and parking lots, as well as atypical items such as stationary wharves and docks, permanently installed cell, broadcasting and electric transmission towers, oil and gas pipelines, and offshore drilling platforms.
If a structure is not listed in the regulations, you must look at certain factors.
- Whether the structure is affixed to the real property including weight alone.
- Whether the asset is designed to be removed or remain in place.
- Whether there would be damage caused to the structure or real property if removed. (e.g. a statue)
- Circumstances surrounding the structure that the expected period of affixation is not indefinite.
- The time and expense to remove the structure.
It is important to know if your relinquished property or replacement property includes personal property. Please consult your CPA and Cost Segregation Specialist to differentiate between real and personal property.
Can I do a Partial Exchange?
- At the close of escrow, they may instruct the closing officer to wire them the funds separate from the exchange funds.
- After the taxpayer has closed escrow on every identified property, they will receive.
- After the 180th day and the exchange has closed.
All It is important to take non-recurring closing costs into account to find your target replacement property value.
Consult your tax/legal advisor to learn more about your specific tax liability prior to the close of escrow.
Can I exchange my vacation rental?
A vacation rental may qualify for an exchange if the following criteria are met:
- It has been owned and held for investment or business purposes for at least 24 months.
- It was rented at fair market rates for at least 14 days of each of the previous 2 years.
- Personal use per year was limited to 14 days or a maximum of 10% of the time it was rented out. For example, if the property was rented for 200 days in the first year the personal use could extended up to 20 days for that year.
More information regarding the requirements for the exchange of a vacation rentals can be found in Revenue Procedure 2008-16.
How does depreciation impact my exchange?
Depreciation allows you to deduct the cost of buying and improving real estate over the useful lifetime of the property. Keep in mind, you are only permitted to depreciate the cost of the building and not the land.
Traditionally the sale of real property will trigger depreciation recapture tax of 25%. Compounded with capital gains tax, and an investor may end up with a large tax bill on the sale of an investment property. By utilizing an exchange, you are allowed to defer not only the capital gain associated with the sale but also the payment of depreciation recapture. Depreciation does not restart the depreciation clock but it allows you to carry the previous cost basis into the new property. Upon the purchase of the new property you will have two depreciation schedules, as follows:
(1) The remaining depreciation is carried over from the previous property continues under the original timeline for the remainder of the 27.5 years, and
(2) The new depreciation will begin with the portion of the additional replacement value for the full 27.5 years and is treated as excess basis and new property by the IRS.
Can your cost basis be adjusted over time? Absolutely! This new number will include the cost of improvements or additions you make to the property. For questions regarding the tax consequences of your property consult with your accountant for details.
What do I do if I have funds left over after my exchange?
Any exchange funds not used to acquire replacement property in an exchange will be returned to you at the end of the exchange – once all identified replacement property is received or the 181st day, whichever occurs first. These funds are subject to capital gain tax and possible withholding. It is important to have clear communication with your lender, agent and tax advisors to ensure all exchange funds are used to receive full tax-deferral in your exchange.
Can I exchange into a REIT?
A REIT (Real Estate Investment Trust) is a company that owns and collects rents on the property within its portfolio. The income generated from the real estate assets are distributed as dividends to shareholders. Because ownership in a REIT is not considered real property, it becomes ineligible for a 1031 Tax-Deferred Exchange. REITS are taxable as a corporation and not real property.
May I purchase Replacement Property in another state?
The short answer is yes. However, it is important to remember many states have what is known as a Claw-Back provision. These provisions may require you to file an annual information return with the state taxing agency and if you fail to file it could trigger a taxable event.
In California, property sold on or after January 1, 2014 are subject to R&TC Sections 18032 and 24953 requiring California resident and non-resident taxpayers who utilize a 1031 Tax-Deferred Exchange on the sale of California property for property outside of California to file form 3840 at the end of every year reporting the asset as tax-deferred.
More information on the California Claw-Back provision can be found here – https://www.ftb.ca.gov/about-ftb/newsroom/tax-news/january-2019/california-like-kind-exchanges-letters-going-out.html
How may I hold title to the replacement property?
We specifically refer to the “taxpayer” as the entity who is listed on title to the property. For example, a property may be held in an individual’s name, LLC, partnership etc. It is very important to establish the entity by which you hold title to the relinquished property before you consider utilizing a 1031 Tax-Deferred Exchange. It is essential to maintain the same title from the sale of your relinquished property to the purchase of your replacement property. If they see a change in Tax-Identification number on the replacement property, the IRS will assume a different taxpayer has purchased the new property, thus invalidating the exchange.
Partnerships- When multiple entities own real estate together, disagreements, changes in strategy, and life changing events may alter the structure of a partnership. Advanced planning may be necessary if you elect to restructure or dissolve a partnership. Please consult your CPA/ Tax Attorney prior to effectuating a 1031 Tax-Deferred Exchange.
Lending- Certain requirements may be needed based on the “taxpayer” or borrowers qualified status.
The person or entity that holds title to and reports an investment property is referred to as a “taxpayer.” Property may be held in a variety of ways, including an individual name, an LLC, or a partnership, to name a few. In order to receive tax-deferral the same taxpayer that sells the relinquished property must also purchase the replacement property. The simplest way to meet this requirement is to mirror the vesting between the relinquished and replacement properties. The following changes in vesting in an exchange generally do not affect the validity of the exchange:
- A taxpayer selling the relinquished property held in a revocable trust and acquiring the replacement property held their personal name. This is commonly a lender requirement.
- A taxpayer selling the relinquished property as an individual and acquiring the replacement property in a single-member LLC. The taxpayer must be the single member.
- A taxpayer selling the relinquished property as an individual and their estate acquires the replacement property because the taxpayer deceases prior to the completion of the exchange.
It is strongly recommended that you consult with your tax professional regarding any variation in title within the exchange properties.
What we are the most common ways to hold title in joint ownership?
1. Tenancy in Common is property held by two or more people without the right of survivorship. It is created expressly by deed or any property acquired by unmarried persons that fails as joint tenancy or fails to state the nature of the tenancy. The tenancy in common can be created at different times, and ownership can be divided into any number of interests, equal or unequal. Each tenant owns a separate legal title to his or her interest. Each tenant can separately transfer their interest. Upon the death of one of the tenants, interest will pass through probate or by intestacy. Deceased’s interest acquires a stepped-up basis to fair market value.
2. Joint Tenancy is property held by two or more people with the right of survivorship. Upon the death of one of the tenants their interest will pass immediately to the surviving tenant. It is created by receiving the same title, at the same time, same interest and all tenants have equal possession to the property. It must be stated on the deed that it is a joint tenancy, there is no presumption. Transfer of one of the joint tenant’s interest will not affect the continuation of the other joint tenants. The person coming into title will be a tenant in common with the other owners. Only the deceased interest acquires a step-up in basis.
3. Community Property is property held by a husband and wife but only in a community property state. The deed needs to expressly state its community property, or any property acquired by married people that fails as joint tenancy or that fails to state the nature of the tenancy. Most married couples will hold title as community property with the right of survivorship so the property will pass immediately to the surviving spouse and there will be a total stepped up in basis to fair market value.
What non-recurring closing costs may be deducted from exchange funds?
Non-recurring closing costs related to a 1031 Tax-Deferred Exchange may be deducted from the exchange funds, effectively lowering your net exchange proceeds.
These costs include the following:
- Title Insurance on the Sale
- Notary/Recording Fees
- Brokerage Commissions
- Tax Advisor Fees
- Transfer Taxes City/County
- Attorney Fees
- Inspection Fees
- 1031 QI Fees
- Referral Fees
- Escrow Fees
- Contractual Conditions of Sale*
What does not qualify for a 1031 Exchange?
Loan fees, lenders premiums, or other fees associated with financing.
Prorated Rent from Tenants
*If a buyer requests certain conditions be met prior to purchasing the property, and these requirements are included in the sale contract, they may be deducted from the exchange funds with no tax consequence. Don’t see your expense listed here? Please consult your CPA about qualifying deductions.
What are my options for Earnest Money Deposits (EMD's)?
During the sale and purchase of real property, the purchase and sale agreement may require an earnest money deposit (EMD). In order to avoid taking constructive receipt of your funds avoiding a taxable event, special considerations must be taken to ensure the validity of your 1031 Exchange.
Relinquished Property: Ensure the closing attorney or escrow holds the funds until the sale of the property closes. At the close of escrow, the funds will be sent to the QI along with the rest of the sale proceeds.
Replacement Property: The taxpayer can use exchange funds towards an EMD on the replacement property.
What happens if you need to send an EMD before your sale property has closed escrow?
You may utilize personal funds as the replacement property EMD to be reimbursed from the sale of your relinquished property. This will allow you to release contingencies and secure your replacement property as early as possible.
What is a "Related Party" Exchange?
A related party exchange occurs when you buy or sell a property in an exchange with a related party. A related party is defined as a brother, sister, father, mother, familial descendant, or corporations of which the taxpayer owns more than a 50% interest. Additional requirements are placed on these transactions as follows:
Selling to a Related Party –
The sale of your relinquished property to a related party may be allowed if:
- You acquire your replacement property from a non-related property.
- Both you and the related party hold the properties acquired for a minimum of 2 years.
Buying from a Related Party –
The purchase of your replacement property from a related party will not be allowed unless the seller is also doing an exchange. This is problematic if the property is the related parties’ primary residence and this would not qualify for an exchange.
Also, related parties are not permitted to swap properties with each other because of implied tax evasion. Cost basis swapping occurs when related parties trade a low basis property for a high basis property with the idea of immediately selling the higher cost basis property because of the minimal capital gains tax. More information on this subject can be found in Revenue Procedure 2002-83.
Careful consideration with your tax advisor is recommended if you are contemplating buying or selling to a related party in your exchange.
When is my exchange reported to the IRS?
The IRS will be notified of your sale when you close escrow on your relinquished property as the closing agent will file a 1099-S. When you file your tax return for that year your accountant should file Form 8824 to report your exchange and effectively defer your capital gain associated with your sale.
Keep in mind, you would need to file for an extension if you need the full 180 day exchange period to complete your exchange before the tax filing deadline. For example, if you sell your relinquished property in December your 180-day exchange period would give you into June to complete your exchange. You would need an extension to your April 15th tax filing deadline to take full advantage of the exchange period.
Does a “Lease Option to Purchase” qualify in the 1031 Exchange?
A lease option occurs when a seller leases a property to a future buyer prior to a sale taking place. The lease option allows a future buyer to make use of the property while they gather the finances to complete the purchase.
Lease Option Check List:
- Consult your CPA to ensure a properly structured transaction.
- Check state/local law to ensure lease payments do not create an ownership interest in the property.
- Any lease payments which apply to the sale price should be forwarded to the closing agent prior to the actual conveyance. *If the seller takes constructive receipt of the funds, they become taxable boot.
What happens if my lender will not provide financing to my multi-member LLC?
Lenders prefer to work with entities considered “bankruptcy remote”. If the lender is requiring the investors to take title on the deed as individuals, due to strict underwriting requirements, we recommend conveying the property into the LLC as soon as the ink dries. We also recommend getting a letter from the lender indicating the request. It is very important each investor consults their CPA or tax attorney to fully understand the requirements.
How can your children keep the low tax basis on an inherited property?
First: Notification must be given to the Assessor. This is accomplished by filing a form called: Change in Ownership-Death of Real Property. This form must be filed with the Assessor within 150 days from the date of death. This from should be filed along with a copy of the death certificate.
Second: If the property is passing from a parent to their children there potentially is property tax savings available in the form of the Parent-Child Exclusion (Prop 58). It allows a child to inherit property from the parents without the property being reassessed. However, it is not an automatic assumption and you must submit the proper applications.
What happens if the property was held in a trust?
If the property has been held in a trust, the trust does not protect the property from reassessment. In a trust situation, the Parent-Child Exclusion must be applied for to receive the savings. Property can also be transferred from grandparent to grandchild if the parent is deceased. One files the Grandparent to Grandchild Exclusion (Prop 193). Applications for both these exclusions must be made within three years following the date of death.
Third: Affidavit of Death. This is a legal document that may be required by the title companies to make the death a matter of public record. This notarized document needs to be recorded along with a copy of the death certificate. This does not negate the need to file the Change of Ownership-Death of Real Property Owner with the assessor.
How do I find my Replacement Value?
Your replacement value is the target value to meet or exceed when buying your replacement property in order to receive full tax-deferral in your exchange.
Your replacement value is calculated by taking the sales price of your relinquished property and deducting any commissions and non-recurring closing costs (generally understood to be one time title and escrow fees).
Can I defer depreciation recapture if I purchase raw land?
Taxpayers are required to depreciate improvements on investment property. Although deprecation is not an IRS election, it is a great tax benefit. When a taxpayer sells an investment property without doing an exchange, a portion of the depreciation is due in the form of depreciation recapture. Depreciation recapture is taxed at 25%.
Since depreciation affects the basis of the property, when an exchange occurs the old basis will transfer into the new property. Whether the property is improved/unimproved land, residential/commercial, agricultural/industrial the depreciation recapture taxes will be deferred if the value is equal to or greater than the relinquished property.