YOUR KEYS TO EXCHANGING
Owners of investment and income properties have access to the greatest real estate wealth building tool ever developed, the 1031 tax deferred exchange.Exchanges don't have to be difficult, however you need to understand a few keys to 1031 exchanging to have an efficient and fully compliant transaction. Here's a list we compiled from an experienced Exchanger. This is their checklist to ensure that they never missed a nuance that might imperil their tax deferred exchange.
THERE ARE DIFFERENT TYPES OF EXCHANGES DEPENDING UPON YOUR CIRCUMSTANCES.
You may exchange investment or income property for many reasons and still defer capital gain and depreciation recapture taxes. The Internal Revenue Service views your exchange of one property and the replacement with another as simply moving your adjusted cost basis from one property to another. This is why they allow the transfer to be tax deferred.THE PROPERTIES YOU EXPECT TO EXCHANGE MUST BE CONSIDERED 'LIKE KIND'
The Internal Revenue Service requires that the property you sell, as well as the property you buy must be like-kind. And, like kind means one of two things. Either property held for investment, or property held for income. This would exclude your personal residence.H3>YOU MUST UTILIZE THE SERVICES OF A QUALIFIED INTERMEDIARY The IRS requires that your exchange be completed with the assistance of a Qualified Intermediary or facilitator. You should use a well-established firm like FYNTEX, so you know that your exchange documentation will be always be correct and that your exchange funds will be safely held in a Qualified Escrow Account between the time you sell and the time you buy.
YOU HAVE A TOTAL OF 180 DAYS TO COMPLETE YOUR EXCHANGE
You must complete your sale and purchase within a total of 180 days or whenever your tax return is due. The tax return qualifier means that if you start your exchange late in the year, you might have to file for an extension in order to receive your full 180 days.YOU MUST IDENTIFY CANDIDATE REPLACEMENT PROPERTIES WITHIN THE FIRST 45 DAYS
While you have a total of 180 days to complete your 1031 exchange, the IRS requires that you identify your candidate or target Replacement Properties within the first 45 days of your exchange period. This identification is usually made to your Qualified Intermediary by completing a form which is kept in your exchange file. Since the 45 day identification period moves so quickly, start looking for new property as early as possible in the process.THERE ARE SPECIFIC RULES FOR IDENTIFYING THE PROPERTY YOU EXPECT TO ACQUIRE
The IRS requires the use of two rules or one exception for identifying potential Replacement Properties.The first is the Three Property rule, meaning you may identify up to three properties of any value.
The second rule is the Two Hundred Percent rule, meaning you may identify more than three properties provided all of the properties you identify do not exceed two hundred percent of the value of the property you sold.
The one exception is known as the Ninety-five Percent exception. You may identify more than three properties and more than two hundred percent of total identified property value, provided you acquire at least ninety-five percent of everything you identified.
THERE ARE THREE THINGS YOU MUST DO TO HAVE A 100% TAX DEFERRED EXCHANGE
If you want a completely tax deferred transaction you must do these three things. First, buy Replacement Property which is equal or greater than the net selling price of what you sold. Two, move all your equity from the old property into the new property. And three, replace your debt.BUY REPLACEMENT PROPERTY AS THE SAME ENTITY IN WHICH YOU SOLD
It is always best to buy as the same entity in which you sold. To change your vesting (to an LLC for example) in the middle of an exchange will create unnecessary risk because the IRS could make a case that your new ownership entity had not seasoned their ownership sufficiently to qualify for deferred gain treatment under Section 1031.1031 EXCHANGE GLOSSARY OF TERMS
Cost Basis: This is where all tax related calculations in an exchange begin. Cost Basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $275,000; your Cost Basis is $275,000.Adjusted Basis: At the time of your sale, it is necessary to determine your current or adjusted basis. This is accomplished by subtracting any depreciation reported previously, from the total of the original cost basis, plus the value of any improvements.
Capital Gain: "Realized Gain" and "Recognized Gain" are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain: reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be "boot". So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non like-kind property in an exchange is taxable. Therefore, boot is taxable.
There are two types of boot, which can occur, in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt, which can arise, between the exchange of relinquished property and the replacement property.
As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.
Let's assume for example that you are selling your Relinquished Property for $375,000 and that it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held by your facilitator.
Suppose that you then find a new property costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of this debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.
Likewise, cash boot reflects the amount of cash or other value received.
New Adjusted Basis: This figure reflects the necessary adjustments to your basis after the replacement property is acquired. Since the amount of deferred gain must be considered, the calculation below will serve as a method for determining the new adjusted basis on the replacement property.