If
you are not familiar with Delayed Exchanges or you just need
a clearer picture of how they work, we've compiled this list
of frequently asked asked questions. We hope this helps. If
you ever have questions about anything below, or even topics
not listed here, please call us for clarification. We'll be
glad to help.
Q:
What is a 1031 Exchange?
A:
When an investor in real property sells that property and
uses all or part of the sale proceeds to buy other investment
real property, that is an "exchange" of "like-kind" property
under Section 1031 of the Internal Revenue Code if the applicable
rules are followed.
Q:
Are there other kinds of exchanges besides 1031 exchanges?
A:
Exchanges of condemned property and shares in privately held corporations
are other exchanges having different rules applying to them.
Q:
How does a 1031 Exchange help?
A:
When properly handled, proceeds from a 1031 exchange can
be reinvested in the newly-acquired property without now
paying any income tax. That means a more valuable piece of
property can be acquired than if Federal and State taxes
had to be paid on the sale of the old property. In effect,
by waiting for its taxes until a taxpayer's investment in
real property is finished (if ever), the government is making
an interest-free loan to help make the new investment.
Q:
Are exchanges gimmicks which careful people should avoid?
A:
Congress and the I.R.S. have recognized the legitimacy of
exchanges for over fifty years. The law agrees it is not
fair to force an investor to pay tax when all that is happening
is a change in the form of her investment. By exchanging,
the investor has not "realized" any gain because
her original investment is still tied up in real property
which is like her original property.
Q:
Can the investor add money to her sale proceeds to buy a more
expensive piece of properly?
A:
Yes. She receives credit for tax purposes (adding to her
tax basis) for the additional investment.
Q:
If an investor owns property with other persons, can they reinvest
separately (or can some reinvest and others take their cash)?
A:
Under 1031, so long as a partnership does not exist (see
a lawyer for help on that question) people owning property
together can reinvest separately under 1031 or some can reinvest
and others not.
Q:
What kind of properties can be exchanged for each other?
A:
The "like-kind" rules presently are very broad
so that raw land can be traded for an apartment house (for
example). The Congress in the past has been on the verge
of tightening the like-kind rules and since tax revenues
would be raised by doing so, changes in this area remain
very possible.
Q:
If the investor is selling more than one piece of property,
can he still perform an exchange?
A:
Yes. Proceeds from several properties can be invested into
one or more properties under 1031 so long as the 180-day
and 45-day rules are satisfied.
Q:
What are the "180-day" and "45-day" Rules?
A:
The purchase of the replacement property must close within
180
calendar days of the closing date of the original property's
sale. That period is shortened if a tax return for the year
in which the sale occurred is filed (so any sales occurring
toward the end of a year may shorten the 180 days unless
the client makes sure he does not file his tax return before
closing his purchase).
The "45-day" requirement
means that the client must have identified the replacement
property within 45 days
of the sale of the original property.
Q:
How does an investor "identify" the replacement property?
A:
The 1990 I.R.S. Regulations say that sending a written statement
to any party to the exchange within the 45 days constitutes
proper identification. If a qualified intermediary were being
used, a letter sent to the qualified intermediary would identify
the property by street address or legal description. Three
properties can be identified (or more if their value does
not add up to twice the value of the property being disposed
of).
Q:
If more than one property is being sold, when do the 45 days
and 180 days start?
A:
If proceeds are being combined to reinvest in one or more
properties, the date of the first closing starts the time
running.
Q:
Why is a qualified intermediary required for delayed exchanges?
A:
The I.R.S.
has consistently attacked exchanges where the taxpayer received
(actually or constructively) funds
from the sale of the original property. Investors must avoid
actual receipt or constructive receipt ("constructive
receipt" means the taxpayer has control over the funds
and can receive them if he wishes). To do that, the funds
must be held by a person independent of the investor pursuant
to a well-prepared exchange agreement that legally and actually
requires that the funds be used only for the purchase of
the replacement investment property. Intermediaries such
as Exchange Holding Services, Inc. exist for the sole purpose
of serving as unrelated third party facilitators of the exchange.
Q:
Can persons other than a qualified intermediary hold the
funds?
A:
In 1990, the I.R.S. issued regulations which validate the
use of a qualified intermediary. They also allow the funds
to be held by the buyer of your property or in a "qualified
escrow account" or in a "qualified trust." If
the funds are held other than by an established qualified
intermediary, you should get advice from your attorney about
whether the fund holder is "unrelated" to you,
is using the proper documents, is trustworthy and is not
charging unfair fees.
Q:
Can I do an exchange if I am receiving a promissory note from
the buyer?
A:
Yes. The cash portion of the sale can be reinvested under
1031. Even principal paid on the note can be reinvested (be
advised by a lawyer or accountant because proper reinvestment
of the note can be tricky). If the note is received and collected
by the investor, the installment sale rules apply.
Q:
What is "Delayed" or "Starker" Exchange?
A:
When an investor sells property before buying the replacement property,
the exchange is considered a delayed exchange (because there is a
delay between when the old property is transferred and the new property
is received). These are also called "Starker Exchanges" because
an investor named T.J. Starker in 1979 won an important case in the
Court of Appeals upholding the legitimacy of delayed exchanges.
Q:
As a Realtor, what should I do about exchanges?
A:
- Ask your client
if they want to reinvest their sale proceeds.
- When you open an escrow with the title company, tell them
this is an exchange.
- The title company will prepare all exchange escrow instructions
and the qualified intermediary will prepare all the exchange documents.
For
more information please call
Janet Wagner or Sharon Horne
at (707) 252-7149.
