When it comes to real estate, all property is like-kind to all other real estate or other tangible property that is similar in nature and characteristics. For example, raw land can be exchanged for an office building; a condominium can be exchanges for farm land.What is considered real estate is defined by each state where the property is located.
The Main Rule
In order to have a fully tax deferred exchange; the replacement property purchased must be equal-or-up in fair market value to the relinquished property being sold. That means you must use the entire net proceeds from the relinquished property to purchase the replacement property.
You must also replace any mortgage paid off at the sale of the relinquished property with an equal-or-greater mortgage on the replacement property. If not you may incur “Mortgage” boot.
The following general guidelines must be used in order for taxpayers to realize their maximum taxable gains:
- The value of the replacement property must be equal to or greater than the value of the relinquished property.
- The equity in the replacement property must be equal to or greater than the equity in the relinquished property.
- The debt on the replacement property must be equal to or greater than the debt on the relinquished property.
- All of the net proceeds from the sale of the relinquished property must be used to acquire the replacement property.
If you do not trade-up in equity or fair market value, the exchange is only partially tax deferred. That means you will owe some capital gain to the IRS.
4. What is boot?
“Boot” is anything of value received by the exchanger which is not “like-kind” to the relinquished property. Boot is characterized as either "cash" boot or "mortgage" boot. Realized Gain is recognized to the extent of net boot received.
4a. Cash Boot
Cash Boot is any cash received by the taxpayer, upon sale of the relinquished property. This will be treated as “cash boot” and tax will be recognized to the extent of gain in the transaction. This boot may be in the form of money or other property.
4b. Mortgage Boot
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable, unless offset when netted against other boot in the transaction.
4c. Other Property Boot
An exchanger can receive other property which can be considered “boot”. For example, if the exchanger receives an automobile, art work, or any other thing of value as part of an exchange, that other non-like kind property will be deemed boot and taxed on the fair market value of the other property received.
4d. The following are examples of the various boot "netting” rules which apply when you have a partially tax deferred exchange:
- Cash boot paid offsets cash boot received
- Cash boot paid offsets mortgage boot received(debt relief)
- Mortgage boot paid (debt assumed) offsets mortgage boot received
- Mortgage boot paid does not offset cash boot received
Property within the United States must be exchanged for property within the United States. The IRS code allows foreign property outside the United States to be exchanged for foreign property, but not with property within the United States. The United States, for purposes of §1031, includes the U.S. Virgin Islands, if you are doing business there.
MEGA 1031 may directly wire the down payment from the funds held on your behalf. Alternatively, you may make the down payment and be reimbursed at the closing of the purchase of your replacement property.
A taxpayer has 45 days after the date that the relinquished property is transferred to properly identify potential replacement properties. This requirement is strictly enforced, even if the 45th day falls on a weekend or holiday.
Identification must be in writing, signed and dated by you and received by MEGA 1031 no later than by midnight on the 45th day after the closing date of the relinquished property.
Replacement property must be clearly identified. Usually either a legal description or a mailing address is sufficient.
The exchange must be completed by the date that is 180 days after the transfer of the relinquished property.
The current identification rules represent a compromise which was proposed by the IRS and adopted in 1984. Prior to that time, there were no time-related guidelines.
The current 45-day provision was created to eliminate questions about the time period for identification and there is absolutely no flexibility written into the rule and no extensions are generally available. The one exception is during natural disasters when Congress can mandate an extension. Should an extension be granted then there is a formal announcement that includes revised 45 & 180 dates, along with special wording that has to be included, in red on the front page of your tax return. If a natural disaster extension applies to your exchange, MEGA 1031 will contact you and walk you through the procedures.
Yes. A fractional part of the relinquished property may be exchanged and/or a fractional part of the replacement property may be acquired.
Title to the replacement property must be taken in the same name in which the relinquished property was held. This rule must be followed even when spouses are involved.
In the recent release of a private letter ruling (PLR20040002) the IRS provided taxpayers with this change to the code. They informed us that a taxpayer could acquire replacement property from a related party in a 1031 tax-deferred exchange, if the related party is also doing an exchange. This is an evolving area in 1031 exchanges. Generally speaking, if an exchange involves related persons or entities, all exchanged properties must be held by the exchanger and the related party for a period of two years after the date of the last transfer or the exchange will not qualify for tax deferral.
Related parties are defined as “lineal ancestors and descendants or brothers and sisters”. The IRS rules governing other relatives vary according to special circumstances. MEGA 1031 can advise you on whether your loved one is considered a related party under current IRS rules.
Sometimes a corporation, partnership or LLC can also be considered related parties. However, regulations governing these situations are complex and somewhat confusing. Let MEGA 1031 help you determine if your exchange qualifies under this IRS code.
Yes, provided the entity selling the relinquished property is the same as the entity purchasing the replacement property.
A partnership interest in one partnership may not be exchanged for a partnership interest in another partnership. A share of stock in one company may not be exchanged for a share of stock in another company. However, legal entities may perform exchanges under 1031.
Yes, this is a reverse 1031 exchange and has greater complexity and fees. However, the exchanger may not hold title to both properties at the same time. Instead an Exchange Accommodation Titleholder (EAT) must hold title to one of the properties.
No. This is NOT considered a like kind exchange by the IRS.
It is best to have the owner of the replacement property perform the repair work prior to acquiring the replacement property. As a second alternative, it is better to use funds other than exchange funds to perform the repairs on the replacement property. Finally, exchange funds can be used to perform repairs on the replacement property if the repair is accomplished prior to the exchanger actually acquiring title.
It is generally best to have the owner of the replacement property perform the fix up prior to acquisition of the replacement property. As a second alternative, it is better to use funds other than exchange funds to perform the fix up on the replacement property. Finally, exchange funds can be used to perform fix up on the replacement property if the fix up is accomplished prior to the exchanger actually acquiring title.
Yes, this is sometimes called a Construction exchange. It is more complex and involves fees. The property is held by a specially formed LLC called an EAT (Exchange Accommodation Taxpayer) which acquires title to the replacement property. The EAT can then perform all the improvements, and you can afterward acquire the replacement property from the EAT under the regulations for exchanges. Please contact MEGA 1031 if you wish to perform a construction exchange.
If your property is converted involuntarily, the time frame for reinvestment is extended to 24 months from the end of the tax year in which the property was converted. You may also apply for a 12-month reinvestment extension. Involuntary conversion is addressed within Section 1033 of the Internal Revenue Code.
Yes, you can exchange multiple smaller properties for a larger one and vice versa. The key is always trade up in value in order to maximize the amount of capital gains taxes that are deferred.
Also, several relinquished properties may be exchanged for a single replacement property. One relinquished property may be exchanged for several replacement properties. But, it is important the exchange be part of a unified exchange agreement from the beginning.
The 45-day identification rule and 180-day replacement rule will start running from the date of the sale of the first relinquished property. Sometimes, because of this timing issue, it is better to structure the exchange as a series of exchanges rather than a multiple leg exchange.
You may identify any number of properties of any value under the three property rule. But when using the 200% rule there is a restriction. This rule states that when identifying four or more properties, the total aggregate value of the properties identified must not exceed 200% of the value of the relinquished property.
An additional exception exists for those whose identification does not qualify under the three property or two hundred percent rules. The 95% exception allows the identification of any number of properties, provided the total aggregate value of the properties acquired totals at least 95% of the properties identified.
The following is a quick review of the three rules pertaining to property identification:
- 3-property rule: You may identify up to 3 properties without regard to their value.
- 200% rule: You may identify more than 3 properties provided that their combined fair market value does not exceed 200% of value of the relinquished property.
- 95% rule: You may identify any number of properties, provided that you acquire 95% of the fair market value of those properties.
Yes, by continuing to trade-up like-kind properties and following 1031 exchange rules, after your death, your heirs can avoid paying capital gains taxes.
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