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The Laurex Process: Exit Strategy Implementation
The Tax-Deferred 1031 Exchange
By Ray Alcorn

This article is an overview of exchanging. Before you actually put one into motion, you should get a qualified attorney and/or CPA to complete the deal. The regulations sound complicated, but once you cut through the mumbo-jumbo, the basic requirements are pretty simple, but they must be followed to the letter.

There are three components to a tax-deferred IRC Section 1031 Exchange:

  • Qualifying property
  • Values
  • Timing

Qualifying Property

The actual definition in the Title 26 Section 1031 of the federal code says "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."

The properties exchanged must be of the same general nature, characterized by being held for investment or use in a trade or business. That opens the door to a whole slew of possibilities, including trading for airplanes, artwork, etc., but for now let’s keeps it simple. Property such as inventories, stocks, bonds, and notes are not considered "like-kind," and are in fact specifically excluded. However they receive similar treatment under other sections of the code. When it comes to real estate, all property is "like kind" to other real estate. The exception is your residence. That is treated elsewhere in the code, and is not included in qualifying properties for Sect. 1031 purposes.

Values

The general rule for a fully deferred exchange is that the exchanger must trade equal or up in:

  • Equity
  • Debt
  • Fair Market Value

That means you must trade for a property or properties that are equal or greater in value, your equity position must be equal or greater than in the relinquished property, and you must owe at least as much or more on the new property(s) as you did on the old. You can trade one property for multiple properties, or multiple properties for one property, as long as the aggregate values and debt are equal or greater.

Timing

There are two basic forms of tax-deferred exchanges. They are a simultaneous exchange, and a delayed exchange. There are multitudes of variations on these two types of exchanges, but they will all fall into one of the two categories.

The Simultaneous Exchange

The most basic type of exchange is the simultaneous exchange, also called an "In Lieu Exchange." In a simultaneous exchange, the Seller wants to sell Property X, for which she has agreed to accept Property Y "in lieu" of cash payment. If the Buyer already owns Property Y, then the two parties simultaneously transfer their respective properties, being careful to adhere to the value rules above. In the case of the Buyer not owning Property Y, then the Buyer must purchase Property Y and transfer it to the Seller simultaneously with the transfer of Property X to the Buyer. In order for the Seller to preserve the tax-deferred status of the transaction, she must not receive any cash or debt relief.

The Delayed Exchange

The other type of exchange is the delayed exchange, also known as the Starker exchange. The Starker exchange gets its name from the court case that established the legality of a delayed exchange, using what is known as a Qualified Intermediary (QI). Fees charged by a QI are fairly reasonable, $500 or less for the first leg of a deal, and less thereafter. In this type of transaction, the Seller closes the sale of her property, and escrows the proceeds of the sale with the QI. In no event can the Seller ever take possession of the proceeds, or the tax deferral status of the transaction will be disallowed. After closing the sale of her property, the Seller then has 45 days to identify in writing to the QI the property or properties to be exchanged for. The identified properties must be purchased within 180 days of the sale of the relinquished property.

Properties must be clearly and accurately identified in writing and MUST be delivered to the QI by midnight of the 45th day. Deletions or substitutions of properties made during the 45 days must also be in writing. There are NO circumstances that will allow for an extension of the identification period.

There are three rules governing the identification of multiple properties:

1. The Three Property Rule: The Three Property Rule indicates that you may identify up to three replacement properties regardless of their fair market value. It is not necessary to purchase all of the identified properties. Even if you intend to buy only one replacement property, it is advisable to identify one or two alternate properties in case the first property purchase falls through. For those who are planning to identify and purchase no more than three replacement properties, the following 200% and the 95% Rules will not apply.

2. The 200% Rule: The regulations permit the identification of more than three replacement properties but only under the following circumstances. The total fair market value of ALL of the identified properties must not exceed twice (200%) of the contract price of the property sold. Exceeding the 200% limit will void the exchange. However, there is one exception to this rule, which is:

3. The 95% Rule: If more than three properties have been identified, and their total fair market value exceeds 200% of the value of what was sold, the exchange may still be valid if 95 % of the total cost of all properties on the list are purchased. This means if there are properties costing $100,000 on your list, then you must purchase at least $95,000 of them.

None of the above-described rules are applicable if all of the acquisition properties are closed within 45 days of the close of your old property. It's easy to see that by planning to acquire multiple properties, avoiding the 200% Rule in particular could be advantageous. Wrapping up the exchange in 45 days may seem difficult, but adequate planning before the exchange begins can lead to a successful close within 45 days. If exchanging out of multiple properties, the first property that closes will begin the 45-day identification period.

Other Variations

There are many variations on these basic structures, including scenarios where there can be a partial tax-deferred gain. For those types of situations you need to sit down with a qualified attorney or CPA that has knowledge about Section 1031 of the Internal Revenue Code. There is specific language that should be included in either sale or purchase contracts to put all parties on notice that one of the parties intends to treat the transaction under Section 1031. Again, this is a straightforward declaration of the intent of the party that wishes to exchange, and does not require any magic document, but the rules have to be followed.

Online Resources

There is a lot of help information online for facilitating exchanges. Some of the sites I have seen and used are:

www.1031X.com

And the actual code can be found at:

www.uscode.house.gov/usc.htm

(search for Title 26 Section 1031)

There is also a firm that several people whose advice I trust and value have recommended to me as a very good company to use as a Qualifying Intermediary. I have not used them personally, but understand that their services are professional, reasonably priced, and most importantly, accurate. That company is Asset Preservation, Inc., and can be contacted at www.apiexchange.com.


Avoiding the Tax Bite

You will find that there is a whole world of new terminology used in structuring exchanges. Don't be intimidated by the terms, just ask what they mean when someone throws one at you. I have found that in many cases people will come up with catchy phrases and terms just to further mystify the process. It isn't necessary, and those professionals that are worth their salt will bend over backward to make the deals understandable.

Once you have a basic understanding of how a 1031 exchange works, you can start thinking about your own situation, where you want to go, and how 1031 may help you get there without paying the tax bite that accompanies the sale of low basis real estate.

I hope that this has been specific enough without being overwhelming. It is a difficult subject to write simply about and still maintain accuracy. Most importantly though, DO NOT rely on my opinion alone. Get a qualified attorney and/or CPA to review your situation before committing to any action.

Article Provided by:

Ray Alcorn
Park Real Estate, Inc.