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Some Basic d1031 Exchange RulesBy Ann Cottrell What is a d1031 tax-deferred exchange? A d1031 tax-deferred exchange allows an owner of investment property to exchange property and defer paying federal and state capital gains taxes if they purchase like-kind property following the rules and regulations of the IRC. “In a d1031 exchange, you exchange Property A for Property B. The sale proceeds from A are used to pay for the purchase of B. By using a "Qualified Intermediary" (also called "Accommodator") to transfer both properties and funds, rather than you doing so directly, your tax liability is deferred.” Section d1031 is quite similar to the traditional IRA or 401K plans. Please note that it is not an exemption. So, the term “tax-free” can be misleading. A d1031 exchange is a powerful tool for wealth creation and allows one to leverage all the equity into a larger property. The d1031 tax law is a federal law and was first enacted in 1921. It is applicable in all 50 states plus, the U.S. Virgin Islands and Guam. The federal capital gains tax rate is currently 15%. What is a Qualified Intermediary? A Qualified Intermediary (QI) is a person/business, who, for a fee facilitates your d1031 exchange. The QI actually holds the proceeds so that you are following the guidelines mandated by the IRC. When doing a d1031 exchange you are not allowed to hold the proceeds from the sale of the property. The proceeds should never touch the taxpayer’s hands and you are not allowed to let your relative hold the proceeds as that is considered “constructive receipt.” Any person that has acted as the agent of the taxpayer, such as a person who has acted as the taxpayer’s accountant, employee, attorney or investment banker within the last two years is disqualified. Why is a d1031 exchange so important? Here is a calculation to show how much money you would have to pay in federal, state and depreciation recapture taxes if you are not deferring the taxes by doing a d1031 exchange.
Facts: $500,000 original purchase price Gain Calculation:Net Sales Price $1,000,000 Adjusted BasisNet Purchase Price $500,000 Taxes: 25% Depreciation Recapture 15% Federal Capital Gains 5.75% VA State Capital Gains So, as you can see this is a powerful tool for wealth creation!! There are non-tax reasons that the 1031 exchange can benefit you. You may own a property that has been fully depreciated which can be exchanged for a more valuable property. Geographical and property diversifications are other non-tax reasons to engage in a d1031 exchange. For example, one can sell an apartment building in California and replace with three office buildings in Virginia. There are many other reasons so please consult with your CPA or investment advisor for more information and careful tax planning. Tax Deferral Requirements
In order to defer 100% of the capital gains taxes you must follow certain rules. First, the purchase property value must be greater than or equal to the sales price of the relinquished property. Second, you must reinvest all of the net proceeds into the replacement property. If you choose to buy for less than you sold or you want to take out some cash you can still do the exchange. It is called a partial exchange and you will be taxed on either the difference of the purchase price and sales price and/or cash not reinvested in the new property. There are some costs that can be deducted from the sales price to offset the purchase price value needed for full deferral. Any direct costs of selling the relinquished property such as real estate commissions, title insurance premiums, closing or escrow fees, legal fees, transfer taxes, notary fees, recording fees or any costs specifically related to the fact that the transaction was an exchange such as qualified intermediary fees, can be deducted from the sales price. Costs that cannot be deducted are any fees involved with additional financing for the replacement property such as mortgage points (and assumption fees), credit reports, Lender’s title insurance, pro-rated mortgage insurance, loan fees and loan application fees, property taxes, utility charges, Association fees, Hazard insurance, credits for lease deposits and any pre-paid rents and security deposits. In order to qualify for the d1031 exchange the properties need to be held for long-term appreciation and held for productive use in a trade or a business. All real estate is “like-kind,” with the exception of property located outside of the U.S. There are five tax classes of property:
Section d1031 applies the first and fourth and perhaps the fifth. Vacation homes may qualify as long as it is not your second home and you only reside at the property for 14 days a year. You may visit the property for routine maintenance when needed but the property either sits empty or is rented for the remainder of the year. The most important point to remember is your intent at the time of purchase. This is important if the IRS audited you. The burden of proof is always on the taxpayer and your intentions at the time of purchase are very important in determining your true investment purposes. There is no specification by the IRS for the amount of time needed to hold the property bought in a d1031 exchange. It is considered a “gray” area but most would agree that one to two years is a substantial holding period. Timing Requirements and Identification Rules
There are some very important timing requirements when doing a d1031 exchange. Before selling your relinquished property you must have contacted your QI to set up the exchange. If close of escrow has taken place then it is too late to do the exchange. You have already started controlling the sales proceeds. On the day of your closing you have the earlier of either 180 calendar days or the due date for your tax returns for the tax year your exchange began. Within the 180 days, you must identify in writing by the 45th day the replacement property. There can be no exceptions!! TIMCOR will need to have your written identification no later than midnight on the 45th day. If your relinquished property closes after October 15th then you actually have less than 180 days to complete your exchange unless you file for an extension on your tax returns. There are some identification rules that must be followed when identifying replacement properties. You are allowed to sell and buy an unlimited amount of properties but you have to follow one of the three identification rules. They are as follows:
Three Property Rule The three property rule allows you to identify up to, but not more than, three replacement properties without regard to the values of the properties. It is wise to identify three properties having two as back up in case the first choice cannot be acquired. If you only had one property identified and you are past your 45th day and are not able to acquire the property, then you have a failed exchange. If you are identifying 4 or more properties and the total value of the properties does not exceed 200% of the sales price of the relinquished property then you are following the 200% rule. For example, if you sold your relinquished property for $200,000 and you want to buy four or more properties, the total combined value of the 4 or more properties cannot exceed $400,000. If you are buying four or more properties with a combined value of more than 200% of the relinquished property then you will be required to close on 95% of whatever you have identified. For example, if you sold your relinquished property for $200,000 and you have identified 6 properties with a total value of $1,000,000 then you will be required to close on at least $950,000 (95% of $1,000,000). Types of d1031 Exchanges
There are five types of d1031 exchanges. They are as follows: Simultaneous/Concurrent The Concurrent Exchange is when you are selling and buying your properties at the same time. The closings are back to back and usually within three days. Sometimes this can be a two party swap but this is very rare. Even though the QI never hold the proceeds because the proceeds are wired from one exchange to the other, there is still documentation required for the legal exchange of properties. The Delayed Exchange is when you sell Property A and then later purchase Property B. Therefore, you are selling first and then buying later. This is when the timing requirements become important because you may be closing on one or all of your replacement properties outside of the 45th day and proper timely identification is important. The Construction/Improvement Exchange is when you are using the proceeds from the sale of Property A to either build or make improvements to property B. The construction takes place as part of the exchange with title passing to the QI who in turn makes payments to the contractors and other suppliers out of the exchange proceeds. This type of exchange follows the same timeline requirements. In order to defer 100% of the gains taxes you will need to have a completed replacement property by the 180th day that has the same fair market value of the relinquished property sales price. For example, your relinquished property sold for $500,000. You bought raw land and are constructing a new building on the land. By the 180th day you will need to have a value $500,000 in this property to defer all the taxes. Also, if the replacement property is of lesser value than the relinquished property an improvement or construction exchange is an effective tool to increase the value of the replacement property to reduce or eliminate paying capital gains taxes on the difference in value. This type of exchange requires careful planning and at least two weeks prior notification to set up the exchange. The Reverse Exchange is when the replacement property is bought before you have sold the relinquished property. Because the taxpayer cannot hold title to more than one property at a time during an exchange, the QI must either acquire the replacement property and warehouse it until the relinquished property sells at which time a concurrent/simultaneous exchange or delayed exchange is structured. Another way this type of exchange can be structured is to have the QI become an interim or “straw” buyer for the relinquished property and then immediately structure a concurrent exchange into the replacement property. This type of exchange also requires very careful planning and at least two weeks prior notification to set up the exchange. The Business/Personal property exchange permits the exchange of property other than real estate. For example, investors may exchange business assets, valuable paintings, livestock, equipment or other personal property. Although these types of exchanges are common, they can be more complicated because they require very specific asset allocations. Also, “like-kind” definitions more limitating. For these reasons, a taxpayer should consult with their CPA before engaging in an exchange and should carefully select the QI. There are three very important considerations when selecting a QI. How long has the company been doing exchanges? How safe is my money with this company? And how much is this going to cost? TIMCOR Exchange has been in business since 1977 facilitating thousands of exchanges each year. TIMCOR has a great track record and, in fact, has the AAA rating by the Better Business Bureau. TIMCOR is a subsidiary of Washington Mutual (NYSE: WM), a multi-billion dollar FDIC insured institution so your funds are very secure. Also, our prices and interest rates are very competitive. Please contact me for more information.
Ann S. Cottrell |
