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Basic Exchange Rules 1. Property must qualify for a tax-deferred exchange. Section 1031 of the IRS Code states that property which qualifies for tax-deferral treatment is any form of property used in a trade or business or held for investment. Any form of investment real estate or any real estate housing or business qualifies. An example of property that would not qualify would be your primary residence or another property that you treat as a second home for tax purposes. 2. You must state that you are planning to do a tax-deferred exchange prior to the sale of your current property. Your intent must be clearly stated prior to the closing of your relinquished property. This should be done in writing. 3. You must acquire "like-kind" property. The meaning of "like-kind" under Section 1031 of the IRS Code is "any form of real estate used in a trade or business or held for investment.” The key word is real property, which should not be confused with other types of investments such as stocks, bonds, personal property or mortgages. 4. For property to qualify as either a relinquished or replacement property, it must be held for investment. You may be wondering if there is a minimum holding period or how held for investment is defined. While code does not specifically state the answer, it says that your intent must be to hold the property for investment and not use it as dealer inventory or what some refer to as "flip property." Many tax advisors suggest that the minimum holding period should be one year. 5. At a minimum, the same amount of debt and cash must be reinvested. To have no tax consequence in an exchange transaction, all of the cash proceeds and at least the same amount of debt that was paid off must be reinvested in the replacement property. If additional cash is needed to acquire the replacement property, an exchangor can provide the funds at closing. It is fine for an exchangor to invest additional cash or place a larger amount of debt on the replacement property than existed on the relinquished property. However, when the replacement property is purchased, if any of the cash is not used or if the debt mortgage is less than the previous amount, then the amounts not reinvested will be subject to tax. The unused cash or debt is referred to as the "cash boot" or "mortgage boot." 6. The exchange transaction must be technically structured as an exchange and not just the sale of one property and acquisition of another. When executing a delayed exchange, it is important to note that actual title is deeded directly on both the sale of the relinquished property and the acquisition of the replacement property. This major rule change was implemented in April 1991. The intermediary creates this exchange transaction by using the proper documents and coordinating the entire process with the closing attorneys or title companies on both the sale and purchase transactions. 7. There are specific identification and acquisition time limits that must be met. There are two specific time frames that govern the process. First, Section 1031 says the exchangor has 45 days to identify new replacement property and the earlier of 180 days or the date of the next tax-reporting period, whichever is earliest to acquire the replacement property. The identification and acquisition start the day after the closing of the relinquished property. Once again, this is the starting point for both the 45 and 180-day time periods. There are no provisions to extend these time frames in the code. The identification and acquisition periods end effective midnight on the 45th and 180th day, respectively. The 180-day acquisition period can be cut short if the closing of the relinquished property takes place near the end of a tax-reporting period. For example, if an exchangor owns property individually and sells his property between October 15th and December 31st of the calendar year, he must close on a replacement property within 180-days or by April 15th, whichever comes first. In this example, April 15th would come first and become the last day of the acquisition period. To take advantage of the full 180-day time frame, the exchangor could file an extension to file his tax return. Once he closes on the replacement property (still complying with the 180-day time frame), he can file his tax return. 8. There are rules regarding the number of properties that can be identified during the 45-day period. Section 1031 of the IRS Code states that the exchangor can identify up to three properties of any value. If an exchangor wants to identify more than three properties, he must comply with the 200% rule. The total value of all properties identified must not exceed two times the value of the relinquished property. There is one exception to the 200% rule. An exchangor can identify numerous properties as long as he acquires properties with total values equal to 95% or more of those identified. Failure to strictly comply with the rules in this area will invalidate an exchange. In order to properly identify property, the code states that a description must be clear enough so that the property cannot be confused with another property. There are a number of ways to comply. Your intermediary will need a written contract with a standard legal description and a simple letter listing the property address and/or legal description. 9. The exchangor cannot have either actual or constructive receipt of any sale proceeds. Section 1031 is very clear about this issue. Actual receipt, simply stated, is obvious. The exchangor cannot actually receive the proceeds. The term "constructive receipt" is more complicated. It means that the exchangor can have only limited control of the funds during the exchange process. Using the intermediary method of exchange, the intermediary holds the funds for the exchangor and will only disperse them based on the restrictions contained in the signed Exchange Agreement. This agreement should clearly state that the exchangor can have only limited access and limited control of the funds during the exchange period. The code does allow for the exchangor to receive the benefit of any interest earned on the funds while held by the intermediary. Our Services | Our Commitment | Basic Exchange Rules | Exchange Benefits | Contact Us |
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