Frequently Asked Questions
Frequently Asked Questions
Everything you need to know and more.
What is a Qualified Intermediary?
A Qualified Intermediary is the entity/person who facilitates Internal Revenue Code §1031 Tax-Deferred Exchanges in accordance with Treasury Regulations. Guidance provided by an experienced Qualified Intermediary may significantly improve your chances of a successful §1031 Tax-Deferred Exchange.
A Qualified Intermediary IS NOT someone who has been a taxpayer’s employee, attorney, accountant, investment banker, broker, or attorney during the 2 years prior to the transfer of their 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 have all the following characteristics:
- Member of the FEA (Federation of Exchange Accommodators);
- Certified Exchange Specialists on staff;
- In-House Legal Counsel;
- Fidelity Bonding and E&O Insurance;
- Separate Qualified Trust Accounts for each Individual Client
- 20+ Years in Business
What does Like-Kind Mean?
Like-Kind property is defined by the Qualified Use of the property. Like-Kind property must be real property held for investment purposes or productive use in a trade or business.
Examples of Like-Kind real property:
- SFH (Single Family Home)
- Condominiums and Townhomes
- Commercial Property (Retail, Industrial, Office, Multifamily)
- Oil and Gas Rights
- Co-ops (30+ Year Lease)
- Delaware Statutory Trust (DST)
- Tenants-in-common Interest in Real Estate (Fee Simple)
Do I need Specific Contract Language?
“[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 completing 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.”
Why do you need specific contract language?
The Internal Revenue Code requires that there is language in both the sale and purchase contracts establishing the investor’s intent to perform an exchange.
Please contact ERI toll-free at (877) 799-1031 with your escrow officer’s/closing agent’s information. ERI will contact them directly to obtain all the necessary documents. The exchange documents can be sent directly to you or to the closing agent for execution. Remember, ERI must be assigned into the transaction prior to the close of escrow on the relinquished property.
What is Boot?
Cash Boot: Any proceeds remaining after the acquisition of the replacement property is 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. *
*The California Franchise Tax Board requires all QI’s to withhold 3 1/3% of mortgage boot.
What does Not Qualify for an Exchange?
Personal Property- Beginning January 1, 2018 the Tax Cuts and Jobs Act limited §1031 exchanges to Real Property. Previously the sale of personal property such as machinery, equipment, artwork, and vehicles could be done tax-deferred under IRC §1031.
Primary Residences- §121 Exclusion provides tax exemption for residences held for at least 2 of the last 5 years. The exclusion amount is $250,000 for a single taxpayer, and $500,000 for a joint taxpayer.
Other excluded property:
- Stocks, Bonds, and Notes
- Inventory (Property held primarily for sale such as a “flip”)
- Partnership Interests and Certificates of Trust
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.
Real Property Ownership Structures
Complex tax issues may arise when partners want to go their separate ways or elect to restructure.
Examples of ownership of real property:
Two or more people that hold a separate undivided interest in the property. This ownership structure allows the investors to stay together or go their separate ways through a 1031 Tax-Deferred Exchange. Make sure they do not classify the (TIC) as a Joint Venture or a Partnership.
Does my Vacation Rental Qualify?
A vacation rental may qualify for a 1031 Tax-Deferred Exchange if the following criteria are met:
1. Property has been owned and held for investment or business purposes for at least 24 months.
2. Property was rented at fair market rates for at least 15 days of each of the previous 2 years.
3. It was nor used for personal use in excess of 14 days or 10% of the time it was rented.
Revenue Procedure 2008-16*
How is my Depreciation affected by a 1031 Exchange?
Depreciation allows an investor to deduct the cost of buying and improving real estate over the useful lifetime of the property. The Modified Accelerated Cost Recovery System (MACRS) applies to any property placed in service after 1986. It will spread the depreciation of residential property equally over 27.5 Years! Remember: You may only depreciate the cost of the building, not the land.
Traditionally, the sale of real property (with no exemptions) will trigger depreciation recapture tax of 25% (Maximum). Compounded with other capital gains tax, and an investor may end up with a large tax bill on the sale of the investment property.
Utilizing a 1031 Tax-Deferred exchange allows an investor to defer the payment of depreciation recapture. Although the depreciation does not simply restart after a 1031 Tax-Deferred Exchange, it allows the investor to carry the previous cost basis into the new property. Upon the purchase of the new property you will have two depreciation schedules:
The remaining depreciation carried over from the previous property will continue the original timeline for the remainder of the 27.5 years.
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 individual property consult with your legal or tax professional.
What do I do if I have funds left over after my exchange?
After Day 180 any funds left in the Qualified Trust account will be returned to the taxpayer subject to the appropriate capital gain taxes. It is important to have clear communication with lenders, agents, and tax advisors to ensure full tax deferral of your capital gain.
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 buy a property in another State?
Yes, but remember many states have what is known as a Claw-Back provision. These provisions may require the taxpayer to file an annual information return with the state taxing agency. If a taxpayer fails to file this information return, it could trigger a taxable event.
In California, and 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.
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.
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?
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.
Earnest Money Deposits and the 1031 Tax-Deferred Exchange
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?
Careful consideration must be taken prior to effectuating a related party exchange. A related party exchange takes place when a taxpayer buys/sells real property 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.
Selling to a Related Party:
The sale of a taxpayers relinquished property to a related party may be allowed if the taxpayer acquires the replacement property from a non-related property. They must also hold this new property for a minimum of 2 years.
Buying from a Related Party:
The purchase of a taxpayer’s replacement property from a related party will not be allowed unless the seller is also effectuating a 1031 Tax-Deferred Exchange. Even under this circumstance, the buyer should consult a tax/legal professional regarding potential tax consequences.
Related Party Swap?
Related parties may not swap properties to each other because of the 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.*
Revenue Procedure: 2002-83*
When is my exchange reported to the IRS?
The IRS will be notified a sale took place when you file taxes during the following year. If you sell your property in December of one year, you may need to file an extension should you need the full 180 days to close on your replacement property during the following year.