The Dirty Dozen Basic Rules of Section 1031 Exchanges
$695 FOR MOST EXCHANGES (1 RELINQUISHED, 1 REPLACEMENT) + $245/ADD’L PROPERTY
Section 1031 of the Internal Revenue Code, which authorizes Tax Deferred Exchanges, is one of the most powerful sections in the Federal Tax Code. Section 1031 allows you to legally avoid/defer paying thousands of dollars in current Capital Gains Taxes when you sell one investment property and roll the proceeds into a replacement property. In order to take advantage of this statute, exchange documents must be in place before you close on the property you are selling and you need to use a Qualified Intermediary (“QI”), which is the role of BlackAcre 1031. You cannot do a 1031 exchange on owner-occupied property – and you do not need a QI in that case. For owner-occupied property, there is a different rule which, under certain circumstances, allows an individual Taxpayer a $250,000 gain without paying any taxes.
For this worksheet, we call the property you sell the “Relinquished Property” or “RQ” and each property you buy is called the “Replacement Property” or “RP.” A Section 1031 Tax Deferred Exchange allows you to legally avoid/defer most or all Federal and State Capital Gains Taxes if you sell property (the “Relinquished Property” or “RQ”) that is “held for productive use in a trade or business or for investment” – rental real estate, for example, and buy other investment real property, the RP. NOTE: This information may appear in a simplified form for illustrated purposes. An Exchange is a very sophisticated transaction. Get professional legal/tax advice and please read the disclaimer at the bottom of this flyer.
1. A valid exchange requires proper exchange documents in place to prove intent, to prevent constructive receipt, to provide an accommodating party BEFORE settlement.
2. Taxpayer cannot have actual or constructive receipt of the funds. – The Settlement Agent wires your exchange funds directly to Commerce Bank (NYSE-CBH & S&P500), which performs the Treasury function and keeps your funds safe in a segregated account with your name on it. You go shopping for property in your own name (or already have one under contract).Then, at your Replacement Property settlement(s), BlackAcre wires the funds directly to your Replacement Property Settlement Agent.
3. Same Taxpayer that sells must be the Taxpayer (“TP”) that buys. This rule follows the titleholder not the maker on the note. If title held by an entity, entities can do exchanges. Sometimes members of LLC or LP want out. Planning as long beforehand is key here or you might need alternative strategies. Sometimes Wife is titleholder and she wants to buy Replacement in name of Husband and Wife. Call to discuss this fact pattern, too. For the entity, you may choose to pay partners from other funds – planning is key. For Husband and Wife, you may need to wait until exchange is old and cold before putting in both names.
4. Trade up or trade even (“TU/TE”). In order to be completely tax deferred, TP must trade up or trade even in debt (or add new cash) and trade up or trade even in their equity – less allowable exchange expenses. RQ example in No. 1, above, has $800K in debt and sells for $2MM. If RP = $1.9MM and is acquired with $700K debt and all $1.2MM in exchange funds, you fail to TU/TE in debt and take $100K in taxable gain, taxed at 25% state+State rate – Note: Land is not depreciated and would be taxed at LTCG rate of 15%. IF RP = $1.9MM and is acquired with $800K debt and $1.1MM in exchange funds, you fail to TU/TE in equity and take $100K in taxable gain. If TP bought RP for $2MM with $1.2MM exchange funds and added $800K in new cash, no gain. When you add in “allowable exchange expenses” such as transfer, recordation costs, brokers fees, exchange fee, etc…, in the real world, with $150,000 in allowable exchange expenses, one might only have $1,050,000 in exchange funds and one can meet TU/TE with a $1,850,000 RP.
5. Qualified property must be held for a qualifying purpose. Qualified Property: Statute disqualifies “stock in trade or other property held primarily for sale; stocks, bonds, notes; other securities; interest in a partnership or multi-member LLC, certificates of trust or beneficial interest. Quick-turn or “flips” or buy/fix-up/resell property may be inventory or “held primarily for sale” and the exchange may not be effective. Proper planning may help. Time owned is one key factor. Properly structured, a percentage interest held as a tenant in common is qualified property. Qualifying Purpose: “held for productive use in a trade or business or for investment.” Not TP’s residence – use Section 121; Not dealer or resale property; vacation property may be OK if rented for fair market value (“FMV”) or held primarily for investment rather than personal use. Professional planning will mean the difference on this one.
6. Notice of Identification – 45 days. Within 45 days of settlement of RQ, in a writing signed by TP, TP must narrow choice of RP and comply with EITHER (1) 3 property rule; OR the (2) 200% rule; OR the 95% rule. The 3 property rule does not inquire into the value of the property – you may ID 3 properties regardless of value. The 200% rule does care about value as a limit on how much TP can identify. The 200% rule states that you may identify any number of properties up to 200% of the fair market value of the RQ. Anything closed on within the 45 days is presumed identified.
7. Notice of Identification – Formal Document. By midnight on Day 45, TP must provide Notice to BlackAcre – (1) in writing; (2) unambiguously ID RP; (3) signed by TP; and, (4) sent. We use the date and time stamp on the fax machine, usually. TP doesn’t have to have the RP under contract for 1031. The 45 day rule is a hard rule written in statute. Expect no exceptions.
8. Like-Kind property – Very broad categories for Real Property. Basically any property for any other real property. Condo for Shopping Center for Office building for Single Family Home for townhouse for industrial for raw land are all OK if the Real Property is held for Qualifying Purpose. See Rule 6, above.
9. Close before midnight on Day 180 or when tax return is due, including extensions. Measure Day 180 from RQ settlement date.
10. Call for info about reverse exchanges, build-to-suit or improvement exchanges, TICs and other varmints.
11. How much can the investor save? Advanced example: Avoid or defer unlimited Fed & State Capital Gains Taxes. [Gain=Sales Price – Allowable Exchange Expenses – Adjusted Basis.] The Fed Recapture Rate still = 25%; Long Term Capital Gains (LTCG) is 15%. Assume a State Tax Rate of 5%. Recapture = 30% (25% Feds + 5% State) and LTCG = 20% (15+5). The amount that must be “recaptured” is the amount you have depreciated. Land is not depreciated. Simplified Example: Property bought for $1MM ten years ago, no capital improvements and depreciated at $25K/year – total Depr = $250K, basis is now $750K. Ignoring transaction costs, if sold for $2MM, tax due = [$250,000 x 30%] + [$1MM x 20%] = $75,000 + $200,000 = $275,000. Avoid that w/1031! Basis in RP if RP costs $3MM. First $2MM – Basis = $750K, next $1MM, basis = $1MM. New Basis in $3MM property = $1.75MM. Note: Debt is not relevant to this calculation. Basis is the touchstone.
12. How much does it cost? For $695, BlackAcre will provide you professional services, prepare the legal documents and perform the escrow function on one RQ and one RP. Each additional transaction is $245. Repeat until rich!! Nationwide, bonded and insured, they have done more than $1.5 billion in exchange transactions. Your funds are kept safe at Commerce Bank (NYSE – CBH) and they will make sure to to make your 1031 exchange easy! You can find someone cheaper online, for sure – should you? I don’t think so! ? Is it a wise choice to try to save a hundred bucks and risk the integrity of your exchange? I don’t think so! ? Are they going to take as good care of you as we are at BlackAcre 1031? I don’t think so! ? If you call someone else, are you going to get to work with an attorney directly on your exchange? I don’t think so! ? Should you call anyone other than BlackAcre 1031 to act as Qualified Intermediary for your exchange? I don’t think so.? Call now! ?
Will you feel smart when you save thousands in an Exchange with BlackAcre 1031? You sure will!!!
So call our Maryland or Virginia office now for your FREE 1031 Booklet and to set up your Exchange.?
DISCLAIMER: To ensure compliance with requirements imposed by the IRS, we inform you that, this communication (including any attachments) does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice and further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. If acting as your Qualified Intermediary in a Section 1031 tax-deferred exchange, BlackAcre cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. BlackAcre recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.