1031 Exchanges in Washington DC

Author: Susan Isaacs | The Isaacs Team

1031 Exchanges in Washington DC are typically facilitated by a Qualified Intermediary, with an experienced real estate agent handling the sale transactions. They’re a key tool for investors of all types, but the Biden administration has proposed significant changes to the 1031 exchange rules that aim to limit eligibility, increase tax rates and cap deferral amounts. Will the 1031 Exchange remain a viable option?

What Are Section 1031 Like Kind Exchanges?

This popular provision in real estate tax law allows investors to exchange one business or investment property for another of like-kind, with no gain or loss recognized under Internal Revenue Code Section 1031.

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

Properties are considered ‘like-kind,’ if they are of the same nature or character, even if they differ in grade or quality.

Location also factors into ‘like kind’ determination. Real properties in the U.S. are generally considered like-kind, regardless of whether the properties are improved or unimproved, but real property in the U.S. and foreign real property are not considered like-kind properties.

1031 Exchange transactions are typically facilitated by a Qualified Intermediary, and an experienced real estate agent.

The IRS And 1031 Exchanges

Whenever you sell business or investment property and realize a gain, you generally have to pay tax on the gain at the time of sale.

IRC Section 1031 provides an exception, allowing postponment of tax on the gain if proceeds are reinvested 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, 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 the property seller receives cash, relief from debt, or property that is not like-kind, however, there may be some taxable gain triggered 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 1031 Exchanges

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 more on this topic.

Take Note

  • Determine type of exchange
  • Time limits apply
  • Hire an intermediary
  • Get professional guidance

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Specifics of 1031 Exchanges

Who Qualifies?

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?

There are a number of ways 1031 exchanges can be structured. Here are the basic types:

  • A Simultaneous Exchange is the simplest type of Section 1031 Exchange. It requires settlement of a relinquished property and a replacement property on the same date, typically back-to-back. This type of exchange is covered by 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 ‘Deferred’ or “Starker” Exchange. They allow disposition of property and subsequent acquisition of one or more other like-kind replacement properties. To qualify as a Section 1031 exchange, a deferred exchange must involve the disposition of a relinquished property and acquisition of a replacement property as mutually dependent parts of a connected transaction.  Strict time frames exist for completion of a delayed exchange, primarily a 45 day limit and an 180 day limit. Delayed exchanges are covered by Safe Harbor regulations;
  • Reverse Exchanges are 1031 exchanges in which the replacement property is purchased and closed on before the relinquished property is sold. 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 sells its relinquished property to close the exchange. After the closing of the relinquished property, or simultaneously, the Intermediary conveys title to the replacement property to the taxpayer. The IRS issued updated 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.

Properties Allowed For Like-Kind Exchanges

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

Holding Periods For Like-Kind Exchanges

The IRS does not clearly define terms for holding periods related to 1031 Like-Kind Exchanges. Their guidance simply indicates that relinquished and replacement properties must have been acquired and “held for investment or for use in a trade or business.”

The amount of time  is not specified in either the code or regulations.

According to FirstBank 1031; “Exchange Professionals generally recommend 1-year. The IRS has ruled that 2-years was adequate in a private letter ruling (Ltr Rul 8429039) but this was not made mandatory.

The position of the IRS is that if a taxpayer’s property was acquired immediately before an exchange, or if the Replacement Property is disposed of immediately after an exchange, the property was not held for the required purpose and the “held for” requirement was not met.

There is no safe harbor holding period for complying with the “held for” requirement. 

1031 Exchange Boot

What’s a “boot” in a 1031 Exchange? Non-like kind properties received in an exchange. Examples include debt relief, installment note payoff (a mortgage, or car loan), 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”.

And here’s a great ‘explainer’ video on boots from Accruit:

Limitations, Computations And Reporting

Limitations Of A Section 1031 Deferred Like-Kind Exchange

While a like-kind exchange does not have to be a simultaneous swap of properties, two time limits must be honored to avoid taxation on the full gain. These deadlines are not extendable under any circumstance or hardship, except in the case of presidentially-declared disasters.

  1. 45 days from the date of sale of the relinquished property: Identify potential replacement properties in writing, signed, and delivered to a party in the exchange such as the seller of the replacement property, or qualified intermediary. Notice to an attorney, real estate agent, accountant or similar persons acting as an agent is insufficient. Replacement properties must be clearly described in the written identification with a legal description, street address or distinguishable name.
  2. 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: Replacement property must be received and the exchange completed. The replacement property received must be substantially the same as property identified within the 45-day limit.

Limitations For Deferred And Reverse Exchanges

Assuming control of cash or other proceeds before completion of the exchange may disqualify the entire transaction as a like-kind exchange, making all gain immediately taxable. Keep the following in mind:

  • 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;
  • Use a qualified intermediary or other exchange facilitator to hold proceeds until the exchange is complete to avoid premature receipt of cash or other proceeds;
  • The facilitator may not be the taxpayer involved in the transaction, nor an agent, broker, investment banker/ broker, accountant, attorney, employee or anyone who has worked for that taxpayer in those capacities within two previous years;
  • Exercise caution in the selection of a qualified intermediary. There are instances of intermediaries declaring bankruptcy, making them unable to meet their contractual obligations to the taxpayer. There are also instances of intermediaries shuttering, and of intermediary theft. As First American Exchange notes; “Investors who lose their money when an exchange company fails not only risk losing all of their cash, but if they have entered into a contract to buy the replacement property, they could be subject to a lawsuit for failure to acquire the property. In addition, they lose their ability to defer gain in a 1031 exchange and, therefore, have to pay the tax that is due because of the sale of their property.” The IRS position is that taxpayers are not able to defer gain in a 1031 exchange if they do not buy replacement property within the 180-day exchange period, regardless of the circumstances. The 45 day Identification Period and 180 day Exchange Period are not permitted extensions, even if they fall on a weekend or legal holiday. The sole extension of up to 120 days is for exchanges that qualify for a disaster extension under Rev. Proc. 2007-56;
  • Another way to exercise caution in dealing with intermediaries is with the type of account used to hold funds. Intermediaries have committed theft of funds from their clients; 1031 exchange accounts, almost always when funds were commingled. Intermediaries can hold client exchange accounts in either a commingled account (most common), or a segregated account. Commingled accounts combine proceeds of all client exchanges managed by the intermediary. Segregated accounts provide separate accounts for each client, which is a more secure option.

Computing The Basis In The New Property

It’s critical that taxpayers and their tax representative adjust and track basis correctly to comply with Section 1031 regulations. The IRS says gain is deferred, but not forgiven, in a like-kind exchange. Taxpayers must calculate and track basis in the new property acquired in the exchange.

See the link above for an explanation of “basis.”  According to the IRS, the basis of property acquired in a Section 1031 exchange is the basis of the relinquished property 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 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. Here’s what IRS Form 8824 asks for:

  • 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

Always consult a tax professional or refer to IRS publications for information on, and assistance with, IRC Section 1031 Like-Kind Exchanges. Research the most current IRS information on 1031 Exchanges and consult your tax professional regarding your specific situation.

Types Of Exchanges | Quick Compare

Forward | Delayed Exchange

The majority of 1031 exchanges are delayed (aka ‘forward’) exchanges. The taxpayer sells the relinquished property, identifies a replacement property within 45 calendar days from settlement on the relinquished property, then settes on the replacement property within 180 days of settlement on the relinquished property.

Reverse Exchange

In a reverse exchange, the taxpayer purchases a replacement property prior to relinquishing the existing property using an  Exchange Accommodator Titleholder, who holds legal title to either the relinquished or replacement property until the relinquished property can be conveyed to a buyer.

EAT

Simultaneous Exchange

The relinquished and replacement properties settle on the same date in a simultaneous exchange. This can occur in a property swap (two parties trade deeds), or ia three party transaction using a qualified intermediary to comply with safe harbor regulations.

Improvement Exchange

An Improvement Exchange (aka ‘Construction, or Build-To-Suit Exchange’) can be structured as ‘forward’ or ‘reverse.’ Taxpayers may rehab or construct a new replacement property, provided the full exchange equity is utilized for completed improvements or as a down payment. The improved  or newly built replacement property must have equal or greater value when deeded back to the taxpayer by the EAT.

Boot Exchange

A ;boot’ is non-like-kind property received in an exchange (such as cash, an installment note, debt relief or personal property). Any non-like-kind property received in an exchange is taxed up to the amount of realized gain from the sale of the relinquished property. Receipt of boot introduces a taxable gain into the 1031 exchange transaction and results in a partially tax deferred exchange.

Partial Exchange

Partial 1031 exchanges occur when the taxpayer either did not trade equal or up in value, or ended an exchange with cash remaining (cash boot). If multiple replacement properties are involved in an exchange, but not all are acquired, a partial exchange can result. Taxpayers may still defer a portion of the depreciation recapture and/or capital gain income tax liabilities, except when trading too far down in value.

International Exchange

Property primarily used in the U.S. is eligible as replacement for U.S. property and foreign property is eligible for 1031 consideration with property held internationally. A 1031 exchange is available to foreign sellers of real property held for productive use in a trade or business, or held for investment purposes, but FIRPTA can apply.

Zero Cash Flow Exchange

Zero cash flow (or “zero”) properties are highly leveraged assets with specific attributes applying 100% of rental income to pay down mortgage debt (“hyper amortization”),  allowing lenders to provide a high loan to value ratio (LTV).  In a fully tax deferred exchange, the seller will not recognize any capital gains tax, must purchase a replacement property or properties using all the net proceeds, and replace the debt paid off on the sale property with new debt of equal or greater value when purchasing the new property (or add an equal amount of cash).

Sources

IRS Publications:
Other Sources:

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