1031 EXCHANGES IN Washington DC

1031 Exchanges in Washington DC are typically facilitated by a Qualified Intermediary, with an experienced real estate agent handling the transaction. In general, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031, according to the IRS.

If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

What Is A 1031 Exchange?
The IRS says; “whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
Drawbacks of a Section 1031 Exchange include a reduced basis for depreciation in the replacement property. The tax basis of replacement property is essentially the purchase price of the replacement property minus the gain deferred on the sale of the relinquished property as a result of the exchange. The replacement property includes a deferred gain that will be taxed in the future if the taxpayer cashes out of his investment. Read moreon this topic.
It’s important to understand rules of 1031 exchanges before initiating such a transaction. Read How Long to Hold Property for Investing Purposes and learn about issues involving the exchange of property between related parties as well as Seller Carrybacks and Dispositions. Consult a list of basic 1031 exchange rules.
Who Qualifies For 1031 Exchanges?

The IRS says owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.

How Are 1031 Exchanges Structured?
To accomplish a Section 1031 exchange, the IRS says, there must be an exchange of properties.  The simplest type of Section 1031 exchange is a simultaneous swap of one property for another. Deferred exchanges are more complex but allow flexibility.  They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties. To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).  Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.  Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations. . A reverse exchange is somewhat more complex than a deferred exchange.  It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days.  During this parking period the taxpayer disposes of its relinquished property to close the exchange.
There are a number of ways 1031 exchanges can be structured. Here are the basic types:
  • A Simultaneous Exchange requires the closing of the relinquished property and the replacement property occur on the same day, usually back-to-back. This type of exchange is covered by the safe harbor Regulations;
  • A Delayed Exchange replacement property closes at a later date than the closing of the relinquished property. This type of exchange is also referred to as a “Starker Exchange.” There are strict time frames established by the Code and Regulations for completion of a delayed exchange, primarily a 45-Day Clock and 180-Day Clock. Delayed exchanges are covered by the safe harbor Regulations;
  • Reverse Exchanges are 1031 exchanges in which the replacement property is purchased and closed on before the relinquished property is sold. Usually the Intermediary takes title to the replacement property and holds title until the taxpayer can find a buyer for his relinquished property and close on the sale under an Exchange Agreement with the Intermediary. After the closing of the relinquished property, or simultaneously, the Intermediary conveys title to the replacement property to the taxpayer. The IRS has issued new safe harbor guidance on Reverse Exchanges;
  • Improvement Exchange is an exchange in which a taxpayer wishes to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. The improvements are usually a building on an unimproved lot, but also include enhancements made to an already improved property in order to create adequate value to close on the Exchange with no boot occurring. The Code and Regulations do not permit a taxpayer to construct improvements on a property as part of a 1031 Exchange after he has taken title to property as replacement property in an exchange. For this reason, the Intermediary must close on, take title and hold title to the property until the improvements are constructed and then convey title to the improved property to the taxpayer as replacement property. Improvement Exchanges are done in the context of both Delayed Exchanges and Reverse Exchanges, depending on the circumstances. The IRS has issued safe harbor guidance on Reverse Exchanges (including title-holding exchanges for construction or improvement).
Properties Allowed For A Like-Kind Exchange

Both the relinquished property you sell and the replacement property you buy must meet certain requirements. Both properties must be held for use in a trade or business or for investment.

Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as “like-kind.”  Like-kind property is property of the same nature, character or class.

Quality or grade does not matter. Most real estate will be like-kind to other real estate.  For example, real property that is improved with a residential rental house is like-kind to vacant land.  One exception for real estate is that property within the United States is not like-kind to property outside of the United States.

Also, improvements that are conveyed without land are not of like kind to land. Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.

Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:

  • Inventory or stock in trade Stocks
  • bonds, or notes
  • Other securities or debt
  • Partnership interests
  • Certificates of trust
Identifying A Replacement Property
How do investors identify a replacement property? With the use of one of the following Identification Rules:
  • 200%: An unlimited number of properties may be identified as long as their fair market value doesn’t exceed 200% of the relinquished property’s selling price. Investors may use a property’s list price to determine its fair market value, however, experts advise selecting properties valued slightly lower to hedge against value increases due to market conditions.
  • 95%: Identification of more than three properties with a total valuation exceeding 200% of the value of the relinquished property if at least 95% of the properties identified are acquired by the investor. A careful valuation of contributing properties is required to successfully qualify for this rarely-used rule.
  • 3 Property: An investor can identify up to three properties for any price as long as the investor closes on one of them as the replacement property. The most favored rule due to its lack of fair market value restrictions.
Limitations Of A Section 1031 Deferred Like-Kind Exchange

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable.

These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties.  The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary.  However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient. Replacement properties must be clearly described in the written identification.  In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

Restrictions For Deferred And Reverse Exchanges
  • Taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable;
  • If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property;
  • One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
  • You can’t act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator;
  • Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
1031 Exchange Boot

Non-Like Kind Properties received in an exchange.

What’s a “boot” in a 1031 Exchange? Simply, it covers non-like-kind property received in an exchange, such as debt relief, installment note payoff (a mortgage, or car loan, for instance), cash (cash out for personal expenditures), or personal property valued to be the “fair market value” of the non-like-kind property received.

How does a boot affect a 1031 exchange? It doesn’t disqualify the exchange, but applies a taxable gain to part of the transaction, effecting a “partially tax deferred exchange” instead of a “fully tax deferred exchange.”

Non-like-kind property received in an exchange is taxed up to the amount of realized gain from the sale of the relinquished property.

Here are some additional boot examples from ipx131.com:

  • Cash proceeds an Exchanger takes from escrow (settlement) before the remaining proceeds are sent to the Qualified Intermediary;
  • Cash proceeds received by the Exchanger, for any reason, at the closing (settlement) of the replacement property;
  • Exchanger’s cash proceeds remaining after the exchange ends;
  • Non-qualified property, such as stocks, bonds, notes or partnership interests;
  • Proceeds taken from the exchange in the form of a note.  An Exchanger can utilize the installment sale rules of IRC §453 to “spread out” the recognition of gain.  In addition, see Exchange Topic “Seller Financing Combined with a Tax Deferred Exchange” for ways to use a Note to defer taxable gain into the Replacement Property;
  • Relief from debt on the relinquished property caused by the assumption of a mortgage or an agreement to pay other debt which is not replaced on the replacement property;
  • Property which is not “like-kind”, for example real property exchanged for personal property
  • Property that is intended for personal use and not for use by the Exchanger as investment or business use property (except as permitted by Revenue Procedure 2008-16). See Exchange Topic entitled “Revenue Procedure 2008-16”.

Here’s a great explainer on boots from Accruit:

Computing The Basis In The New Property

It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations. Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange. The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments.  This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition.  A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

Reporting Section 1031 Like-Kind Exchanges To The IRS

You must report 1031 exchange2 to the IRS on  Form 8824 Like-Kind Exchanges and  file it with your tax return for the year in which the exchange occurred. Form 8824 asks for:

  • Descriptions of the properties exchanged;
  • Dates that properties were identified and transferred;
  • Any relationship between the parties to the exchange;
  • Value of the like-kind and other property received;
  • Gain or loss on sale of other (non-like-kind) property given up;
  • Cash received or paid;
  • Liabilities relieved or assumed;
  • Adjusted basis of like-kind property given up;
  • Realized gain

If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals.

Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes.  Many promoters of like-kind exchanges refer to them as “tax-free” exchanges not “tax-deferred” exchanges.

Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.

Consult a tax professional or refer to IRS publications listed below for additional assistance with IRC Section 1031 Like-Kind Exchanges. Be sure to look up the most current IRS information on 1031 Exchanges and consult your tax professional regarding your specific situation.

Additional Resources:

For expert answers to your 1031 Exchange questions:

Brian McNulty

1031 Like-Kind Exchange & Qualified Intermediary Services at IPX1031

Investment Property Exchange Services, Inc. (IPX1031)

m: 781.789.5050  o: 312.489.0804

e: [email protected]  w: www.ipx1031.com/mcnulty