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Every Section 1031 exchange transaction is different. These "Frequently Asked Questions" are intended to answer general inquiries. The application of these principles will depend on the specific facts of each transaction. Always consult a competent Qualified Intermediary, attorney, or tax advisor to determine how an exchange may best be structured to accomplish your investment objectives.
Q - What is a tax-deferred exchange?
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of "like-kind", while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a "paper" gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Q - What are the benefits of exchanging vs. selling?
A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes. Any gain from depreciation recapture is postponed. You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.
Q - How do I initiate a 1031 tax deferred exchange?
It’s easy!
Step 1 - Contact Granite Exchange at: 877-937-1031 or order online at www.ges1031.com.
Step 2 - Provide: Title company information, escrow number and contact information.
Step 3 - Granite Exchange will step in and guide the Exchanger through the process.
Q - What are the general guidelines to follow for a taxpayer to defer all taxable gain?
The value of the replacement property must be equal to or greater than the value of the relinquished property. The equity in the replacement property must be equal to or greater than the equity in the relinquished property. The debt on the replacement property must be equal to or greater than the debt on the relinquished property. All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
Q - What are the keys to 100% tax deferral?
- Trade for like-kind property.
- Trade equal or up in equity and debt.
- Identify replacement property within 45 days from close of escrow or relinquished property pursuant to requirements.
- Acquire replacement property within 180 days of close of escrow of relinquished property or the tax return filing date, whichever occurs first.
- Let Granite Exchange guide the process to ensure the safety and security of your exchange
Click here to view/print a Step-by-Step Exchange Guide.
Q - What are the different types of exchanges?
There are several types of exchanges. Click here to go to the “Types of Exchanges” pages.
Q - What are the requirements for a valid exchange?
Qualifying Property - Certain types of property are specifically excluded from Section 1031 treatment: property held primarily for sale; inventories; stocks, bonds or notes; other securities or evidences of indebtedness; interests in a partnership; certificates of trusts or beneficial interest; and chooses in action. In general, if property is not specifically excluded, it can qualify for tax-deferred treatment.
Proper Purpose - Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer's personal residence will not qualify.
Like-Kind - Replacement property acquired in an exchange must be "like-kind" to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
Exchange Requirement - The relinquished property must be exchanged for other property, rather than sold for cash and using the proceeds to buy the replacement property. Most deferred exchanges are facilitated by Qualified Intermediaries, who assist the taxpayer in meeting the requirements of Section 1031.
Q - What are the time restrictions on completing a Section 1031 exchange?
A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties. The exchange must be completed by the date that is 180 days after the transfer of the relinquished property, or the due date of the taxpayer's federal tax return for the year in which the relinquished property was transferred, whichever is earlier. Thus, for a calendar year taxpayer, the exchange period may be cut short for any exchange that begins after October 17th. However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
Q - What are the requirements to properly identify replacement property?
Potential replacement property must be identified:
- To the “QI” (Granite Exchange Services) or any other person that is required to transfer title to the Exchanger;
- in a written signed document;
- faxed, mailed, hand delivered, or otherwise sent and;
- by midnight of the 45th day of the exchange period.
A "disqualified" person is any one who has a relationship with the taxpayer that is so close that the person is presumed to be under the control of the taxpayer. Examples include blood relatives, and any person who is or has been the taxpayer’s attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property. The identification cannot be made orally.
Q - Are Section 1031 Exchanges limited only to real estate?
No. Any property that is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. In fact, many exchanges are "multi-asset" exchanges, involving both real property and personal property.
Property that Qualifies as “Like-Kind”
Q - What does not Qualify?
A personal residence, stock in trade (developed lots), property held for resale immediately after acquisition or completion of improvements (spec. homes or fixer-upper types that are not rented or held for a reasonable period of time) and partnerships interests. Second homes may or may not qualify depending on use and tax.
Q - Is there any limit to the number of properties that can be identified?
There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these rules:
3-Property Rule: The taxpayer may identify up to 3 potential replacement properties, without regard to their value; or
200% Rule: Any number of properties may be identified, but their total value cannot exceed twice the value of the relinquished property, or
95% Rule: The taxpayer may identify as many properties as he wants, but before the end of the exchange period the taxpayer must acquire replacement properties with an aggregate fair market value equal to at least 95% of the aggregate fair market value of all the identified properties.
Q - What if the taxpayer cannot identify any replacement property within 45 days, or close on a replacement property before the end of the exchange period?
Unfortunately, there are no extensions available. If the taxpayer does not meet the time limits, the exchange will fail and the taxpayer will have to pay any taxes arising from the sale of the relinquished property.
Q - Can the taxpayer just sell the relinquished property and put the money in a separate bank account, only to be used for the purchase of the replacement property?
The IRS regulations are very clear. The taxpayer may not receive the proceeds or take constructive receipt of the funds in any way, without disqualifying the exchange.
Q - If the taxpayer has already signed a contract to sell the relinquished property, is it too late to start a tax-deferred exchange?
No, as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property, she can still set up a tax-deferred Exchange. Once the closing occurs, it is too late to take advantage of a Section 1031 tax-deferred exchange (even if the taxpayer has not cashed the proceeds check).
Q - When can I take money out of the exchange account?
Once the money is deposited into an exchange account, funds can only be withdrawn in accordance with the Regulations. The taxpayer cannot receive any money until the exchange is complete. If you want to receive a portion of the proceeds in cash, this must be done before the funds are deposited with the Qualified Intermediary.
Q - Can the replacement property eventually be converted to the taxpayer's primary
residence or a vacation home?
Yes, but the holding requirements of Section 1031 must be met prior to changing the primary use of the property. The IRS has no specific regulations on holding periods. However, many experts feel that to be on the safe side, the taxpayer should hold the replacement property for a proper use for a period of at least one year.
Q - Does the Qualified Intermediary actually take title to the properties?
No, not in most situations. The IRS regulations allow the properties to be deeded directly between the parties, just as in a normal sale transaction. The taxpayer's interests in the property purchase and sale contracts are assigned to the QI. The QI then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, taxpayer).
Q - What is the difference between "realized" gain and "recognized" gain?
Realized gain is the increase in the taxpayer's economic position as a result of the exchange. In a sale, tax is paid on the realized gain. Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.
Q - How do I inform parties in my transaction that I am performing a 1031 exchange?
You may choose to use one of the following clauses, or a similar provisions, in your contract when obtaining the cooperation of the Buyer or Seller in your transaction.
Buyer Clause - Relinquished Property (addendum “A”)
Buyer is aware that Seller has entered into an agreement to exchange his/her/their relinquished property to Granite Exchange Services, Inc.(GES) and that Buyer’s signature to this Agreement is not a commitment to purchase the subject property but is given only to facilitate the terms of such exchange. Seller shall have the right to assign his rights and obligations under the Agreement to GES and, as a result of that assignment; Buyer shall receive title to this property from GES. Buyer agrees to enter into an Assignment Agreement at the request of Seller.
Seller Clause - Replacement Property (addendum “B”)
Seller is aware that Buyer has entered into an agreement to exchange his/her/their replacement property to Granite Exchange Services, Inc.(GES) and that Buyer’s signature to this Agreement is not a commitment to purchase the subject property but is given only to facilitate the terms of such exchange. Buyer shall have the right to assign his rights and obligations under the Agreement to GES and, as a result of that assignment; Buyer shall receive title to this property from GES. Seller agrees to enter into an Assignment Agreement at the request of Buyer.
Q - What is Boot?
Boot is any property received by the taxpayer in the exchange which is not like-kind to the relinquished property. Boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.
Q - What is Mortgage Boot?
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.
Q - What is Cash Boot?
Cash Boot is any boot received by the taxpayer, other than mortgage boot. Cash boot may be in the form of money or other property.
Q - What are the boot "netting" rules?
Cash boot paid offsets cash boot received
Cash boot paid offsets mortgage boot received (debt relief)
Mortgage boot paid (debt assumed) offsets mortgage boot received
Mortgage boot paid does not offset cash boot received
The “Boot” Test:
The "Boot Test" is a device to determine if there is a potential for taxable "boot" in a transaction. It is not a substitute for tax counsel, but it can be a thumbnail analysis to allow one to know if an exchange will be fully or partially tax deferred. The test is done to verify that the exchanger is moving up and across in value, equity, and mortgage.
Example:
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Phase I (sale property) |
Phase II (acquisition) |
Across or Up? |
| Sale Price: |
$200,000 |
$225,000 |
√ |
| Mortgage: |
$100,000 |
$125,000 |
√ |
| Equity: |
$100,000 |
$100,000 |
√ |
This is an example of a fully tax deferred exchange. The Equity has been moved across into the next property, and there is a Mortgage of equal or greater value to the Mortgage on the Phase I property.
If you do not see an answer to your specific question listed above, please contact a Granite Exchange Consultant at 877-937-1031.
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Federation of Exchange Accommodators
