Top Ten 1031 Exchange Misconceptions

1.  Like-kind means I must exchange the same type of property, such as apartment building for apartment building.

 

All real property is like-kind to other real property, but personal property

like-kind requirements do have some restrictions. Real property and personal property are not like-kind to one another.  To read more about like-kind real estate, go here.

 

2.  My attorney can handle this for me.

 

Not if your attorney has provided you any non-exchange related legal services within the two-year period prior to the exchange. To read more about qualified and disqualified parties, go here.

 

3.  I must literally “swap” my property with another investor.

 

No. A 1031 exchange allows you to sell your relinquished property and purchase replacement property from a third party. Watch a short video on the basic process of a 1031 exchange.

 

4.  1031 exchanges are too complicated.

 

They don’t have to be. An experienced Qualified Intermediary will work with you and your tax and/or legal advisors to make sure the process is as seamless as possible.  Go here to read frequently asked questions and answers about doing a 1031 exchange.

 

5.  The sale and purchase must take place simultaneously.

 

No. The taxpayer has 45 days to identify the new replacement property and 180 days to close.

If you would like more information on the identification time period, go here.

 

6.  I just need to file a form with the IRS with my tax return and “roll over” the proceeds into a new investment.

 

No.  A valid exchange requires much more than just reporting the transaction on Form 8824.  One of the biggest traps when not structured properly is the taxpayer having actual or constructive rights to the exchange proceeds and triggering a taxable event.  For more information on tax filing requirements, go here.

 

7.  1031 exchanges are only for real estate.

 

No. Almost any property, whether real or personal, which is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. For more information on personal property exchanges, go here.

 

8.  All of the funds from the sale of the relinquished property must be reinvested.

 

No. A taxpayer can choose to withhold funds or receive other property in an exchange, but it is considered boot and will be subject to federal and state taxes.  To understand more about boot, go here.

 

9.  1031 exchanges are just for big investors.

 

No. Anyone owning investment property with a market value greater than its adjusted basis should consider a 1031 exchange. To find out how to use 1031 exchanges as a retirement planning tool, go here.

 

10.  I must hold property longer than a year before exchanging it.

 

The 1031 regulations do not list a time requirement on how long you must hold property, but it does say that property must be “held for productive use in a trade or business or for investment”.

To learn more about holding period requirements, go here.

from First American Exchange Company “The Exchange Update”

 

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Yes, You Can Use 1031 Exchange Funds to Improve Your Replacement Property

Many people are familiar with the “law of fixtures”.  In general, when an item of personal property becomes affixed to a parcel of real estate, that personal property is transformed into real property.  For example, a cabinet is personal property in the home improvement store.  When you bring it home and install it on your kitchen wall it becomes a fixture, and thus real property.

It seems logical, then, that improvements to a replacement property must be like-kind property.  But not so fast…

When it comes to tax-deferred exchanges, timing is everything.  Once the Exchangor takes title to the replacement property, the exchange is completed.  Subsequent improvements will not qualify for tax deferral, even if the funds come from the sale of the relinquished property.

Exchangors often ask if they can use exchange funds to purchase materials that will not be installed in the replacement property until after the closing, or pre-pay for construction services that will be performed at a future date.  The answer in both cases is “no”, even if the payments are disbursed through escrow as part of the replacement property acquisition.

Here is the reasoning.  The exchange begins when the Exchangor transfers real property.  If the Exchangor receives real property plus materials and/or construction services in return, only the real property is like-kind.  To qualify for tax-deferred treatment, the materials have to be real property (i.e. affixed) at the time the Exchangor acquires the replacement property.  Similarly, any construction services performed on the replacement property must be completed prior to closing.  Reg §1.1031(k)-1(e)(4).

So what can be done?  One possible solution is to ask the seller to make the improvements prior to closing, in exchange for a higher selling price.  The purchase contract can be structured so that the Qualified Intermediary pays exchange funds to the seller as additional earnest money deposits or as direct payment for the improvements.

If the seller will not cooperate, the alternative is an improvement exchange.  Similar to a reverse exchange, an improvement exchange requires that a third party take title to the replacement property.  The third party should not be someone who is a related party to the Exchangor under the deferred exchange regulations.  This deal structure gives you a cooperative seller who can make the desired improvements before the end of the exchange period.

In most instances the transaction will be structured in accordance with Rev. Proc. 2000-37.  The Qualified Intermediary, or an affiliate, acquires the replacement property through a single member limited liability company (i.e. Exchange Accommodation Titleholder or “EAT”).  The purchase price may be paid using exchange funds, obtaining a loan to the EAT from a bank or the Exchangor, or some combination thereof.  Unlike in a reverse exchange, the parked property should not be leased to the Exchangor, to avoid constructive receipt issues.

No matter how the transaction is structured, care must be taken to ensure that the replacement property is properly identified.  It is not enough to simply identify the underlying real property.  The improvements should also be identified, especially if they will be extensive enough to change the basic nature or character of the property.  The exchange will qualify even if the improvements are not completed prior to the end of the exchange period (unlike personal property exchanges which require that the replacement property be 100% complete).

An improvement exchange requires careful planning and involves higher transaction costs, but a properly structured improvement exchange will enable an Exchangor to get the property he wants, along with the maximum in tax deferral.

from  First American Exhange Comapny

The Exchange Update

A Newsletter For 1031 Tax-Deferred Exchanges

 

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