Property Type

The first key to a successful 1031 exchange is recognizing the difference between investment property and personal property. Property type is determined by your usage of the property. Section 1031 deals with deferring the taxes on an exchange of property "held for productive use in a trade or business or for investment" and is not applicable for property generally held for personal use.

Section 1031 allows for the exchange of non-owner occupied real property such as a rental home, duplex, apartment building, farm, raw land, or a tenant-in-common interest in an office building. Any property that is owner occupied as a primary residence will not qualify for tax deferral under Section 1031 unless there is mixed use in the same dwelling unit. Section 121 deals with primary residences, which have better tax breaks than those for investment properties. Second homes, vacation condos, and recreational lots are part of a special group and are usually considered personal property and are not eligible for tax-deferred exchange unless personal use of the property amounts to 1) less than 10% of the time the property is rented or 2) no more than 14 days in a year.

Holding Period

The second key concerns the holding period for investment property. At issue is how long a property must be held to qualify as “held for investment” prior to exchanging it and how long a replacement property must be held after the exchange. While there is no definitive answer in the Internal Revenue Code or from the IRS, some guidelines have been developed through IRS requests of Congress and through court cases. Following these guidelines will provide a considerable degree of safety.

Most investment properties have been held in fee simple form for several years. Property should generally be held for more than 12 months (and preferably 18 to 24 months) before being actively marketed or any action taken to convert the property to personal use. This guideline can be used for both the relinquished property and the replacement property. In certain circumstances, property can be held for less than a year, but that is an exception to the rule.

If a direct swap with relatives or other related parties is permissible, the timing is clear: two years. If either property transferred in an exchange involving related parties is disposed of within two years, the entire exchange is disqualified. Related parties include family members -- brothers, sisters, parents, and lineal descendants -- as well as any corporation, partnership, trustee, or other fiduciary relationship where the exchanger owns or controls more than 50%. Related parties must file form 8824 for two years following an exchange. Specific language should be included to prevent any prohibited action by either party, as failure to follow these guidelines by either related person disqualifies the exchange benefits of both.

Same Taxpayer Requirement

The third key involves the form of ownership of the exchange properties. Property can be held in various forms of title including Individual, Joint Tenancy, Community Property, Corporation, Partnership, LLC, and Trust, for example. Exchange rules require that the same taxpayer selling the relinquished property must be the same taxpayer acquiring the replacement property. A husband and wife are considered a single taxpaying entity. A partnership can exchange property for new property in the name of the partnership; however, individual members of a partnership are considered to be owners of shares or interests in the partnership itself and not the actual owners of the real property held by the partnership. Partnership interests are specifically excluded from tax-deferred exchanges; therefore, careful consideration must be made on how partners get in and out of partnerships that own exchangeable real estate.

Valid Exchange

The fourth key is to make sure an exchange takes place. Tax-deferred exchanges differ from a sale and a purchase in several important ways. Listed below are the distinguishing characteristics of an exchange and how they differ from separate purchase and sale transactions.

1. The first difference is the way in which the property value is transferred. If the property is temporarily converted to cash that is available to the taxpayer, the IRS considers the transaction indistinguishable from a sale and disqualifies the transaction from being an exchange. The funds must be held by a third party (such as a Qualified Intermediary) under strict conditions. The taxpayer cannot have constructive use of or access ot the funds at any time during the exchange.
2. The sale and purchase transactions must be interrelated. Merely having two transactions occur simultaneously or at nearly the same time is not sufficient. The Purchase and Sale Agreement, escrow instructions, and other documentation must be specific in stating that one property is to be exchanged for another like-kind property. When using a third party Qualified Intermediary (QI), the documentation on both the sale side and purchase side of the exchange should reference a common QI. In a direct swap with another party, the exchange must be reflected in the title transfer.
3. The taxpayer must sell property that is owned for property that is not owned. While this sounds simple enough, situations can occur where a taxpayer might want to exchange property for other property held through a business or entity in which the taxpayer has an interest or other disqualifying relationship. Proceeds from a sale usually cannot be used to improve a separate property (i.e. a piece of raw land) also owned by the exchanger. Simply put, a taxpayer may not trade with him/herself.

Target Replacement Values

The fifth key involves meeting targeted replacement values. For the capital gain and depreciation recapture taxes to be totally deferred, the newly acquired replacement property must meet three targets: 1) The property acquired must be of equal or greater fair market value than the property sold. 2) At least as much debt liability as is on the relinquished property must be carried onto the replacement property. Lower debt is considered debt relief, which is considered a benefit to the taxpayer and is taxed. Additional cash added by the taxpayer to the purchase of the replacement property can be used to offset differences in debt amounts. 3) All net cash from the relinquished property sale (after selling expenses and debt payoff) must be applied to the purchase of the replacement property. If the replacement property value, debt, or cash is less, a partial exchange will take place and the greatest shortfall in meeting any of the three targets will be taxed, not to exceed the total amount of the gain.

Cash or other property received in an exchange when the replacement property is of lesser value than the relinquished property is called “boot.” Back in 1921 when section 1031 came into existence someone might have said “For your property I’ll give you my five acres and a horse to boot.” In this example, the horse would not be considered like-kind property and its value would be taxable. In the terms of IRC §1031, boot is property not used “for productive use in a trade or business or for an investment” or property received that is unlike the property given up. Any cash or non-like kind property taken out of the transaction by the taxpayer is considered boot and is taxable.

Time Frames

The sixth key is adherence to the very specific time frames involved in a tax-deferred exchange. This is one area in which the Treasury Department has given very clear directions in its regulations published in 1991. Exchangers must be keenly aware of the 45 day identification period and the 180 day exchange period.

The Internal Revenue Service requires that replacement property be unambiguously identified by the 45th day after closing of the relinquished property. Unambiguous means specific identification such as a street address, plat and lot, metes and bounds, or tax lot number. A loose identification such as, “A lot on the north end of Bainbridge Island” would not qualify. This identification must be made in writing and be in the hands of a Qualified Intermediary by midnight of the 45th day.

There are three ways to identify potential replacement properties. The method most applicable to each situation may be used. They are:

1. Up to three properties may be identified without restriction as to value or any requirement to acquire more than one of those properties identified. One, two, or all three of the properties may be acquired in the exchange. This is known as the Three Property Rule, and is the method most commonly used.
2. Any number of properties may be identified as long as the aggregate fair market value does not exceed twice the value of the property sold. Any number of these properties may be acquired in the exchange. This is known as the 200% Rule, and is sometimes used.
3. Any number of properties of any value may be identified as long as 95% of the value of all properties identified is acquired. This is known as the 95% Rule, and is rarely used.

Property with a mutually signed purchase and sale agreement or property that is acquired within the 45 day identification period is considered to be properly identified.

The acquisition of one, several, or all of the identified properties must be completed by the 180th day after closing of the relinquished property. The transaction must be closed and recorded by that date. These dates are not negotiable and are not altered or extended by weekends or holidays.

Intent

The seventh key to a successful 1031 exchange is to recognize that both form and intent are critical to show that an exchange transaction qualifies for tax deferral under the code. Intent is measured on the date of the exchange by all the events that occur before and after the exchange. Facts and circumstances surrounding the exchange must demonstrate compliance with the requirements of a valid exchange, and must also show a good faith effort to act within the intent of the Code.

As with any investment, including real estate transactions, investors should always consult with a qualified tax advisor to obtain the best advice for their own particular situations.