Most investors exchange because they want to use the equity in a property to acquire a more desirable replacement property. Rather than selling and paying taxes (and depleting the amount of cash available for the reinvestment), the investor enters into an exchange. An exchange allows all sheltered gain to be transferred to a replacement without recognition of gain. That is, payment of tax.
Although this is often called a tax-free exchange, it is really a tax-deferred exchange. The investor has sheltered the gain for the moment. In a future sale, Uncle Sam will claim his taxes on gain on the replacement property and on gain sheltered from a prior sale. However, the investor can take advantage of an exchange again and again.
Exchanges can be used to defer taxes in a number of otherwise taxable transactions:
• In a sale of a property that would be taxed, gain can be sheltered through an intermediary, such as CASTERLINE HENRIKSBO EXCHANGE SERVICE COMPANY.
• When an investor wants to move investments into another market, a tax-free exchange allows sale in one place and purchase in another.
• Some properties have no further use in their current form and need to be developed, (farms in suburban areas and warehouses in retail areas are two common examples). An exchange allows the owner to sell to someone prepared to make better use of the property and to invest the proceeds into another useful property.
• Tax-deferred exchanges can sometimes be used to produce improvements and otherwise develop property.
COMMON TERMS USED IN 1031 TAX DEFERRED EXCHANGES
The person doing the exchange. The I.R.S. refers to that person as the taxpayer.
Relinquished and Replacement Property:
These name the property exchanged from and the property exchanged into. The relinquished property is sometimes called the exchange property. The replacement property is sometimes called the target or acquisition property.
Like Kind Property:
An I.R.C. §1031 exchange words if the exchange is for like kind property. This is not a problem when dealing with real estate. As long as the property is to be held for productive use in a trade or for investment it will be like kind to property which was held for productive use in a trade or business or for investment.
Some find this confusing because a building lot does not seem the same as a rental which is not the same as a business property which is not the same as a long term lease. They are all like kind to each other.
When doing a residential rollover or replacing real estate with insurance, the test is held for similar use or purpose. This rule has not been imposed on I.R.C. §1031 although it was seriously considered in 1989 and the decision not to was reviewed in 1983.
This is a term for property which does not match the relinquished property. It comes in four forms:
1. Proceeds not used to acquire the replacement. This is normally cash but could be a note or contract kept by the exchanger.
2. If there was debt on the relinquished property, there must be equal or greater debt or additional value put into the replacement property. Not doing this creates a tax problem equal to receipt of the same amount of cash.
3. Property which is not like kind can be boot. Personal property cannot be traded for real property. In a personal property exchange there are complicated rules and receipt of boot in the form of property not like kind is common.
4. Property not held for a permitted use. If a person sells a rental and buys a personal residence or a property with some personal use to it, this will be boot.
WHAT HAPPENS IN AN EXCHANGE
Before Escrow Opens Property is listed. Sometimes there is a cooperation clause in the listing agreement. A Sale Agreement (Earnest Money Agreement) is signed. Often there is a cooperation clause. At some point, the accommodator is contacted and information provided. This might not happen before escrow opens.
Escrow Is Opened. The Sale Agreement is deposited in escrow. A title report is ordered. They are sent to the accommodator. The accommodator produces an exchange agreement and other documentation and sends it to escrow, the exchanger, and others for review and eventual signing. In escrow, the accommodator acts as the seller. In other words, the instructions, the closing statement, and other documentation relating to the sale of the relinquished property and receipt of proceeds is in the name of the accommodator. All proceeds are received by the accommodator. If a note or contract is taken back, the accommodator is the payee on the note or the vendor on the contract.
Identification Period. After escrow closes, the exchanger has forty-five days to identify potential replacement property to the accommodator. Normally the accommodator sends a letter notifying the exchanger of deadlines and providing a form for identification.
The identification must be in writing and signed by the exchanger. It must be sent to the accommodator before midnight on the forty-fifth day after the transfer of the relinquished property. The property must be unambiguously described which means by street address or legal description. The exchanger may identify three alternative properties (and acquire one or more) or else can identify property worth no more than two hundred percent of the sale price of the relinquished property.
Replacement Escrow. In the second escrow, the accommodator is acting as buyer. It will need a copy of the title report and earnest money agreement. It will be the signer of the instructions and approve the closing statement. The accommodator will also need to be given the option to send money to replace the earnest money or to pay down debt.
Multiple Purchases. If there is money left, the accommodator may use it to purchase additional property. The procedure will require additional replacement escrows.
Accounting. Once all property has been purchased, the accommodator prepares an accounting for the exchanger. That plus any remaining funds will be sent to it.
Although the average exchange has a routine character, it is possible to run into problems. These are some of them:
Failure to Discuss Exchanges with Sellers
Many would-be exchangers do not exchange because they do not understand what is required to effectively put together an exchange. Can a real estate agent be liable by not talking exchanges. Perhaps. The real reason to do this is to develop the reputation of being competent in exchanges. Expertise draws clients.
Failure to Tell Escrow
Escrow officers are wonderful in all respects but they are not telepathic. If they do not know, they cannot prepare a transaction as an exchange. There have been some real tragedies.
If there is paper taken back as part of the exchange, it will complicate the exchange. It is possible but difficult to do an exchange under such circumstances. It is better to avoid paper, if possible. It cannot be avoided, it is crucial that the exchanger have the advice of a well-qualified C.P.A.
Relief of Debt
If a contract or trust deed is paid off, the debt must be replaced. Failure to replace it is taxable as if cash was received.
Changing Parties in the Middle of the Exchange
If the owner of the relinquished property is an individual, a spouse cannot be added until after the exchange is over. The same applies if the owner is an inter vivos trust. Lenders often impose requirements which inconvenience the transaction.