Saturday, July 05, 2008 

What is an Exchange?

A tax-deferred exchange is a transaction involving the transfer of one or more pieces of investment or income property and the receipt of like-kind property: "like-kind" defined as property that will be held for investment, income-producing purposes, or for productive use in a trade or business.  Under IRC Section 1031, the investor is able to defer the recognition of capital gain taxes that would otherwise be incurred on the sale of investment property.  The investor can then use the entire amount of the equity to purchase other investment real estate.  To qualify as an exchange, the relinquished and replacement properties must be "like-kind" properties, and the transaction must be structured as an exchange.

Types of Exchanges

Delayed Exchange - Existing or relinquished property is sold with the replacement property or properties being identified within 45 days and acquired within 180 days of the relinquished propety or the due date of the tax return, whichever occurs first.  More than one relinquished property and more than one replacement property may be included as part of the same exchange.  Special attention should be given to the form required for identification, as well as the multiple replacement property rules.

Simultaneous Exchange - The simultaneous exchange occurs with the simultaneous or concurrent transfer of your relinquished property for the replacement property.  To avoid the requirement for the third party deed and the subsequent double payment of transfer tax, most exchangors will engage the services of a Qualified Intermediary for this type of exchange.

Business/Multi-Asset Exchange - When a business is sold, the sales price is allocated among different asset classes.  These asset classes, with certain exceptions, may be exchanged for assets of another business that is of the same class.

Construction/Improvement Exchange - A construction or improvement exchange refers to the nature and acquisition of the replacement property.  If the replacement property is yet to be built, proceeds from the transfer of the relinquished property will be used by the Intermediary for the Intermediary's acquisition of the replacement property and to make the required improvements.  Once the improvements are in place and prior to the 180th day, replacement property is transferred to exchangor.  As a variation of this concept, improvements to an existing structure, which will comprise the replacement property, are handled much the same way.  The Qualified Intermediary acquires tide to the replacement property, pays for the improvements and then deeds the improved property to exchangor prior to the 180th day.  Attention should be given to financing issues, should financing be required to complete the exchange.

Reverse Exchange - A reverse exchange occurs when the replacement property must be acquired prior to the transfer or sale of the relinquished property.  In September 2000, the IRS issued Safe Habor guidelines for reverse exchanges defining the exchange period for a reverse exchange to be 180 days.  Additionally, it is required that the exchangor assigns certain rights and obligations under the contract to an Exchange Accommodation Title Holder (EAT) for purposes of acquiring title to one of the exchange properties and for providing other required services.  A reverse exchange, and the related concept of a reverse/construction exchange, is far more complex than other types of exchanges and requires proper planning, well in advance of the closing.

Benefits of Exchanging

• Defer capital gain, allowing the exchangor to use all of the equity to purchase other property or properties.
• Affords the exchangor the opportunity of combining several smaller pieces of property and exchanging into one larger piece of real estate; conversely:
• Allows the exchangor to exchange out of one larger piece of property into several smaller pieces.  This type of exchange is sometimes strategically used to ease out of the ownership of investment real estate, if the investor so desires.  Each of the smaller pieces of real estate may be sold at different times, different tax years, allowing the investor to pay taxes a little at a time, rather than in one lump sum.
• If desired, the exchangor may move the investment real estate to another city or state to accommodate a job transfer, retirement or lifestyle change, or to take advantage of market areas that once were a good investment but now are not as desirable.
• Exchange into replacement property in a tenant in common relationship as to an undivided interest with adult children, allowing children an opportunity to own the remaining interest as their first home and at the same time successfully deferring tax on gain for the exchangor.

1031 Exchange Basics

• The investor should consult with a financial advisor, accountant and/or tax attorney to determine whether or not a 1031 exchange is in their best interest.
• Exchangor's intent must be to exchange.  Exchange language could be added to both the sale and purchase contracts.  This is not a requirement; however, it does clearly define the intent of the exchangor from the beginning of the transaction.
• Trade for "like-kind" property: investment or income-producting property.
• Follow the 45-day and 180-day rules.  Exchangor is required to identify replacement property within 45 days from the date of transfer of title of the relinquished property and to acquire title to any and all replacement property within 180 days of such date, or the due date of the tax return including any extensions, whichever comes first.
• Follow identification requirements: Three Property Rule and 200% Rule (more than three properties).
• Acquire property of equal or greater value to defer all tax on the gain.

For more information about 1031 Exchanges, feel free to visit http://www.eie1031.com.