Q. Why do I need a Qualified Intermediary?
Q. Can anyone serve as a Qualified Intermediary?
Q. What characteristics should my advisors and I look for in selecting a Qualified Intermediary?
Q. If I select a Qualified Intermediary, do I still need a legal or tax advisor?
Q. How do I identify a replacement property?
Q. What happens if I change my mind about buying a replacement property and want to cancel my exchange?
Q. What happens if I sell a property and then decide I want to make it a part of a tax-deferred exchange?
Q. What is "boot"?
Q. Do I need to do a tax-deferred exchange for my personal residence?
Q. Do I have to spend all of the proceeds from my relinquished property on replacement property?
Q. If I don't spend all of my proceeds when can I receive the unused amount?
Q. Can I combine multiple relinquished properties into one replacement property?
Q. If the replacement property is a rental, how long does it have to remain a rental before it can be converted into a primary residence?
Q. If the replacement property is sold, how are the capital gains taxes calculated?
Q. What is Internal Revenue Code "Section 1031"?
Q. How do I know if my transaction is a 1031 Exchange?
Q. Why should a real estate broker or agent understand exchanging?
Q. What is "like-kind" property?
Q. Why exchange property instead of just selling it?
Q. When is a 1031 Tax-Deferred Exchange applicable?
Q. What is the current identification period and closing time to accomplish a delayed 1031 Tax-deferred Exchange?
Q. What happens to the money?
Q. What is a qualified intermediary?
Q. Do I need a qualified intermediary?
Q. What is needed when the exchanger is a partnership, corporation, or trust?
Q. How should the exchanger's name be vested in the deed?
Q. Is a 1031 exchange always 100% tax deferred?
Q. What is boot?
Q. Why do I need a Qualified Intermediary?
A. A Qualified Intermediary is necessary to create the exchange of properties required under section 1031. A Qualified Intermediary simplifies the exchange process by accepting a transfer of your property, conveying it to the buyer, taking custody of the proceeds, buying the replacement property, and transferring title to you. It is a sensitive role requiring experience, special knowledge, and extreme care to preserve the tax-deferred character of the transaction.
Q. Can anyone serve as a Qualified Intermediary?
A. No. There are certain persons who may not act as your Qualified Intermediary. Generally these include relatives, or someone who, within a two-year period prior to your exchange, has acted as your attorney, accountant, real estate broker or agent.
Q. What characteristics should my advisors and I look for in selecting a Qualified Intermediary?
A. Experience, financial stability and customer satisfaction are factors that you should consider. Diversified Wealth Builders will assist you in arranging for a reputable Qualified Intermediary.
Q. If I select a Qualified Intermediary, do I still need a legal or tax advisor?
A. Qualified Intermediaries are appointed to carry out the exchange and prepare the necessary documentation for tax-deferral; Qualified Intermediaries are precluded from counseling you on the desirability or tax implications of an exchange.
Q. How do I identify a replacement property?
A. The identification of a replacement property must be submitted in writing, unambiguously described, signed by you, and delivered or sent before midnight of the 45 th day from the date of the transfer of your relinquished property. Diversified Wealth Builders will assist you with this requirement.
Q. What happens if I change my mind about buying a replacement property and want to cancel my exchange?
A. If you transfer the relinquished property and do not replace it with another, the sale will create a taxable event and any capital gains will be subject to federal and state capital gains taxes
Q. What happens if I sell a property and then decide I want to make it a part of a tax-deferred exchange?
A. If you actually or constructively received proceeds from the sale, it might not be possible to include that property in a tax-deferred exchange. That's why it's important to note your intention to make this transaction a part of a tax-deferred exchange in the contract to sell the relinquished property. If you have entered into a contract to sell, but have not closed, it may be possible to carry out a deferred exchange, provided you execute the proper exchange documents, identify the replacement property within 45 days of the closing, and actually receive it within 180 days or before your tax return is due. Your attorney or tax advisor can help you make this determination.
Q. What is "boot"?
A. "Boot" can be cash received from the sale of the relinquished property or other non-cash consideration, including any property that is not "like-kind," promissory notes, or debt relief (mortgage boot). If you receive boot in an exchange, it is likely that all or some portion of the boot will be taxed.
Q. Do I need to do a tax-deferred exchange for my personal residence?
A. No, your personal residence is not considered property held "for productive use in a trade or business" or "for investment," and therefore does not meet the requirements of section 1031. However, Internal Revenue Code Section 121 allows an individual to exclude from taxation up to $250,000 of the capital gain realized on the sale of the individual's principal residence. A married couple filing jointly can exclude up to $500,000.
Q. Do I have to spend all of the proceeds from my relinquished property on replacement property?
A. No you do not, however you will be taxed on the amount you don't spend. Unused proceeds are known as "boot" and are taxed on their face value at the capital gains tax rate.
Q. If I don't spend all of my proceeds when can I receive the unused amount?
A. You can receive unused proceeds at any time after you have acquired each one of the properties identified within your 45-day identification. If you do not acquire all of the properties identified within the 45-day identification, then the unused proceeds cannot be released until the due date of your tax return, including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.
Q. Can I combine multiple relinquished properties into one replacement property?
A. Yes, you can combine multiple relinquished properties into one replacement property. The rule here is that the first relinquished property to close starts the clock running for all the rest. All the relinquished properties to be combined must be closed within 45 days of the first one to close. The same replacement property is then identified for each relinquished property to be combined. Treas. Reg. 1.1031(k)-1(b)(2)(ii).
Q. If the replacement property is a rental, how long does it have to remain a rental before it can be converted into a primary residence?
A. There are no hard rules here. What the IRS requires is that you show intent to use the replacement property as a rental.
Most of the tax attorneys that we talk to feel that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
Q. If the replacement property is sold, how are the capital gains taxes calculated?
A. The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 exchange.
The trick here is to be able to establish the basis on the new property at the time of sale. The basis on the new property is the sum of the basis transferred from the old property, plus the difference between the sale price of the old relinquished property and the new replacement property, minus the depreciation on the new replacement property.
Q. What is Internal Revenue Code "Section 1031"?
A. Section 1031 of the Internal Revenue Code relates to the disposition of property that is held for use in productive trade or business or held for investment. If performed properly, code section 1031 provides an exception to the rule requiring recognition of gain upon the sale or exchange of property. In other words, if the requirements of a valid 1031 exchange are met, capital gain recognition can be deferred until the taxpayer chooses to recognize it. The current Federal tax rate (maximum) on long term capital gains is 28%, plus any applicable state taxes. Long term capital gains are not taxed as ordinary income. For an exchange to be 100% tax deferred, the Exchanger must acquire replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property. Many specific requirements must be satisfied in order to complete the exchange properly. With the recent IRS Regulations in place, an experienced qualified Broker, Intermediary and Escrow/title officer can accomplish an exchange with ease.
Q. How do I know if my transaction is a 1031 Exchange?
A. The best way to confirm if you have an exchange is to ask the principals involved. Here are some helpful hints to determine if someone may want to perform an exchange:
Is the property the seller's residence?
If yes, then the seller will not be eligible for a 1031 Exchange.
Does the buyer intend to live at the property? If yes, then the buyer will not be eligible for a 1031 Exchange.
Is the property intended for investment purposes?
If yes, then either the seller or buyer might want to perform a 1031 Exchange.
Q. Why should a real estate broker or agent understand exchanging?
A. In today's real estate climate, it is imperative that real estate brokers and agents understand the options a 1031 Exchange can offer their clients. Without such knowledge, brokers and their agents are open to potential liabilities, due to lack of knowledge. Unfortunately, brokers can be as liable for what they don't say, as well as for what they do say. Simply offering the option of a tax-deferred exchange can eliminate potential liability on the broker's part. The "exchange agent" can have more satisfied clients by offering them the option to save substantial tax dollars through exchanging. The exchange agent can also increase their income with the additional knowledge of exchanging.
Q. What is "like-kind" property?
A. The IRS Code Section 1031 states that property held for use in productive trade or business, or property held for investment is potentially exchangeable. One can therefore qualify for non-recognition of gain upon the disposition of such property, assuming all other requirements are met. This means that business property or property held for investment, may be disposed of to a buyer (sold), set up with a Qualified Intermediary and put into escrow, (which will document the transaction as an exchange), and within the codified time frame, repurchase replacement property of "like-kind" - thereby completing the exchange. It is not required that exactly the same type of property is acquired. In 1989, the IRS attempted to change the meaning of "like-kind" to "similar use", and unfortunately, many people believe that is the case. The attempt was defeated. "Like-kind" property that can be exchanged under the current meaning of Code Section 1031 can include: PROPERTY THAT IS HELD FOR PRODUCTIVE USE IN A TRADE OR BUSINESS, OR, PROPERTY THAT IS HELD FOR INVESTMENT. "Like-kind" property can include, but is not limited to, any of the following provided it is held for investment: commercial, single family rental property, condos, raw land, apartments, vacation homes, second homes, duplexes, industrial properties and a leasehold interest of 30 years or more.
A person's PRIMARY RESIDENCE does NOT come under the rules of Section 1031, and is specifically EXCLUDED, as is property held "primarily for resale" or dealer property.
A common misconception to "like-kind" is that the properties being exchanged be of "similar use". This is simply not true. A commercial property can be exchanged for an apartment complex or bare land exchanged for a single-family rental.
Q. Why exchange property instead of just selling it?
A. The most important reason is to be able to defer potentially taxable gain one may realize from a sale of the property. This way one may be able to use All OF THEIR EQUITY to acquire another property, instead of the amount of equity left over after paying applicable Federal and State income taxes on their gain. Additionally, the ability to go from one type of property to another allows an investor to utilize these other concepts: leverage, diversification, cash flow, consolidation, management relief, and possibly increase their depreciation.
It is possible under the current IRS Section 1031 rules to continue to exchange properties, using all of your equity, thus possibly increasing your portfolio Net Worth than if you were you to sell your properties(s), pay the taxes, then acquire another property with the remaining equity.
Q. When is a 1031 Tax-Deferred Exchange applicable?
A. It is applicable when the property in question falls within the "like- kind" definition and the principal intends to BUY another property of "like-kind" within 180 calendar days following the close of escrow from the SALE, and when the investor has a recognizable gain.
CAUTION must be exercised in this area. Property does not have to appreciate in value to have a gain!! The property may have a "built in" gain as a result of a previous exchange or from depreciation taken. Be sure to consult with your legal and/or tax advisor.
Remember, under the delayed exchange parameters, there is a maximum of 180 calendar days to purchase replacement property. Therefore, if the principal is not sure at the time of closing the sale property, it is imperative that the transaction be structured as an exchange rather than a sale. Otherwise, if escrow has closed without the exchange in place, the principal will have receipt of proceeds and cannot perform an exchange.
The worst-case scenario is that if the exchange is "set up" and the principal decides not to buy replacement property and takes the proceeds, the principal just pays taxes as s/he normally would. Without the exchange being "set up", the principal does not have that option. An informed client/seller will appreciate the flexibility.
Q. What is the current identification period and closing time to accomplish a delayed 1031 Tax-deferred Exchange?
A. After an exchange has been arranged by contacting a qualified intermediary prior to closing a sale, the seller/exchanger must identify up to three (3) potential properties they MAY intend to acquire, within 45 days of the close of the "sale" escrow. It is immaterial what the value is of the potential properties.
One can list or identify four (4) or more properties however, these properties cannot have an aggregate value of 200% or more of the sale property. If more than three (3) properties are identified, and the value exceeds 200% of the sale price, then you must close escrow on 95% of the list. Escrow must close, on at least one of the identified properties, within 180 calendar days from the date of the close of the sale escrow. Be sure to check with your legal and/or tax advisor.
Q. What happens to the money?
A. In the 1 st Phase I of the Exchange, it is imperative that the seller/exchanger (who is the owner of the property) does NOT receive any money. The seller's net proceeds are wired to the intermediary into a separate, interest-bearing account. Each exchange has its own account, therefore, you must call the Intermediary BEFORE wiring to obtain the account number. If not, the wire will probably be returned to you due to insufficient information.
In the 2 nd Phase of the Exchange, the funds required to close the transaction will be sent to you from the exchange account held by the Intermediary. You will need to contact the intermediary to find out exactly how much money is in the exchange account. In the event there is insufficient funds in the exchange account to close your escrow, then the exchanger will have to deposit the additional funds required to close the escrow.
Q. What is a qualified intermediary?
A. Paramount to any exchange is a competent qualified intermediary. The intermediary is the entity which structures, consults, guides and documents the exchange transaction from beginning to end. A sound intermediary will provide safety and security for the funds held and provide the technical experience needed to maintain the integrity of the exchange. They do not replace competent tax or legal advice. Quite the contrary, they are not allowed to give tax or legal advice, as this could disqualify them as an intermediary.
Q. Do I need a qualified intermediary?
A. In the regulations of 1991, many of the "grey areas" were clarified in Section 1031 of the Internal Revenue Code, and established the Safe Harbor provisions.
Safe Harbors include:
1) The use of a qualified intermediary;
2) Receipt of interest or "growth factor" by the exchanger;
3) The use of a qualified escrow account; and
4) The use of security instruments in an exchange (such as the use of a qualified intermediary; qualified escrow/closing and trust accounts; third party guaranty).
Q. What is needed when the exchanger is a partnership, corporation, or trust?
A. There is nothing different in how the exchange is handled, but the intermediary will need to see a copy of the Trust Agreement, the Partnership Agreement, or a Corporate Resolution.
Q. How should the exchanger's name be vested in the deed?
A. To have a valid exchange, the exchanger's vesting should be exactly the same in the Phase II transaction as it is in the Phase I. Therefore, if the exchanger owns the relinquished property in his/her personal names, the exchanger should not try and put the replacement property into a family trust until after the exchange is closed.
Q. Is a 1031 exchange always 100% tax deferred?
A. No. For an exchange to be 100% tax deferred, the exchanger must acquire a replacement property that is of equal or greater value and spend all of the net proceeds from the relinquished property.
Q. What is boot?
A. Boot is defined as any non "like-kind" property received by the exchanger in the exchange and it is taxable.
1) Cash Boot:
Cash Boot consists of any funds received by the exchanger, either actually or constructively. If an exchanger does not spend all of the proceeds from the sale of the relinquished property, he/she will have actual receipt of the balance not spent and pay taxes on that amount.
Constructive receipt of funds may occur in a case where the exchanger carries back a note from his/her buyer of the relinquished property, then sells that note at a discount. The exchanger never actually receives funds for the discounted amount, however, he/she has constructively received that discount and pays tax on that amount.
2) Mortgage Boot or Debt Relief
Mortgage Boot occurs when the exchanger does not acquire debt that is equal to or greater than the debt that was paid off, therefore, they were "relieved" of debt. If the exchanger does not acquire equal or greater debt on the replacement property, they are considered to be "relieved of debt", which is perceived as taking a monetary benefit out of the exchange. Therefore, the debt relief portion is taxable, unless offset by adding equivalent cash to the transaction. More to it than just spending all the exchange equity!!
So, an exchanger must buy a property of equal or greater value while spending the NET (after costs) equity. It is absolutely acceptable to take cash out of the exchange and pay taxes on that amount only.
IMPORTANT: If the exchanger wants cash out of the 1 st PHASE of the exchange, the intermediary must be notified immediately. The cash out must come directly out of the closing of Phase I and not from the intermediary. Once the exchange equity is in the "Qualified Escrow Account" at the intermediary's, the exchanger cannot access the funds until the end of the exchange.
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