A successful IRC §1031 exchange transaction requires planning ahead and additional preparation, expertise and support. A skilled Qualified Intermediary can be very helpful in the early stages of preparing for an exchange by explaining the various types of exchanges, discussing the options that may minimize or eliminate any negative tax impact, handling the exchange documentation and safeguarding the exchange equity. Laying the proper groundwork before a taxpayer enters into an exchange will enable the taxpayer to seek tax and/or legal advice prior to starting an exchange, especially since answers to the following questions could indicate that an exchange may be partially or fully taxable or that a more complicated structure may be required:
Is the property being sold (relinquished property) held as a business-use or investment property and does the Exchanger intend to do the same with the replacement property?
Is title in the replacement property going to be held in the same manner as title is held in the relinquished property?
Does the lender for the replacement property have any specific requirements for holding title that would cause problems with the exchange?
Will the proceeds be used to Exchanger’s pay personal debt?
Will all parties in title to the relinquished property be participating in the exchange? Will additional parties be added to title in the replacement property?
Is the Exchanger selling property to or intending to buy property from a related party?
Does the Exchanger plan to offer seller financing on the sale of the relinquished property?
Keep in mind the three basic rules to qualify for complete tax deferral:
1) All proceeds from the relinquished property must be used for purchase of the replacement property;
2) Debt on the replacement property must be equal to or greater than the debt on the relinquished property. (Exception: a reduction in debt can be offset with additional cash whereas increasing debt cannot offset a reduction in equity); and
3) The Exchanger must receive only “like-kind” replacement property.
Possible replacement property/ies must be identified within the 45-day identification period and replacement property/ies must be acquired within the 180-day exchange period.
The dissolution of partnerships or change in the manner of holding title during the exchange which alters the Exchanger’s legal relationship with the property may jeopardize the exchange.
When replacement property is located and must be closed before sale of the relinquished property, a reverse exchange should be considered.
The IRS has provided guidance for reverse exchanges in Revenue Procedure 2000-37. The reverse exchange is considered far more complicated and is therefore typically more expensive because the Qualified Intermediary must take on an additional role in the transaction, as that of Exchange Accommodation Titleholder (EAT). Title to either the relinquished property or replacement property must be held in the EAT (“parked” in the exchange) pending successful sale and closing of the relinquished property which must occur within 180 days of title passing to the EAT (the exchange period).
If improvements to the replacement property are intended before the Exchanger acquires title to it, then both the replacement property and the planned improvements must be identified and the EAT must hold title to the replacement property during the 180-day exchange period while the improvements are constructed. An exchange in which the replacement property will have improvements made to it before it is acquired by the Exchanger is known as an “Improvement” or “Construction/Build-to-Suit” Exchange. The improvements might be minor, in the case of a remodel, or they might be major, like constructing a building to required specifications. An Exchanger must meet three basic requirements in order to defer all of their gain in an improvement exchange as follows:
Number One: spend the entire exchange equity on completed improvements or down payment by the 180th day;
Number Two: receive substantially the same property they identified by the 45th day; and
Number Three: the replacement property must be equal or greater value when deeded to the Exchanger. The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property.
It is important to note that the improvements need to be in place prior to the Exchanger taking title to the replacement property. However, the new replacement property does not necessarily have to be fully completed within the 180 day exchange period. A certificate of occupancy is not required.
The ability to refurbish, add capital improvements, or build-to-suit, while using tax deferred dollars, can create tremendous investment opportunities for an Exchanger.
This information is not intended to replace qualified legal and/or tax advice. Every taxpayer should review their specific transaction with their own legal and/or tax counsel.