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The information on this web site is only intended to provide a guide after consulting with your accountant and or tax attorney.
Exchange Corporation of Montana has no control over links from this web site and does not endorse
any external internet site that contains links or references. All links are intended for information only.
Copyright © 2010 by Exchange Corporation of Montana ( ECOM ) · All Rights Reserved · P.O. Box 11387 · Bozeman, Montana 59719 · 406.388.4764
Exchange Corporation of Montana has no control over links from this web site and does not endorse
any external internet site that contains links or references. All links are intended for information only.
Copyright © 2010 by Exchange Corporation of Montana ( ECOM ) · All Rights Reserved · P.O. Box 11387 · Bozeman, Montana 59719 · 406.388.4764
P.O. Box 11387 • Bozeman, Montana 59719 • 406.388.4764 • 800.579.1031 • Fax: 406.388.4784
The “Basic Rules”
1. There must be a reciprocal exchange of “Qualifying-Like Kind” property.
2. There must be the intent to exchange and an Exchange Agreement.
3. The transaction must be structured as an exchange and not a sale.
4. There must not be constructive or real receipt of the exchange funds.
5. Replacement property must be identified within 45 days of the close of the relinquished property.
6. The entire exchange must be completed within the sooner of 180 days from the date of close of the relinquished property or the due date, including extensions, of the filing of the Exchanger’s tax returns for the taxable year in which the transfer of the relinquished property occurs.
QUALIFYING PROPERTY
To qualify for tax deferred treatment under IRC Section 1031, you must reciprocally exchange property which has been held for productive use in a trade or business or held for investment, for “like- kind” property which will be held for productive use in a trade or business or held for investment purposes.
EXAMPLES OF QUALIFYING PROPERTY:
1. Condos
2. Retail Stores
3. Vacant land
4. Ranches
5. Hotels
6. Offices
7. Shopping Centers
8. Apartments / Duplexes
9. Single Family rental
10. Farms
11. Leasehold property with a lease of 30 years or more to run. An exchange of fee title for a leasehold with a remaining term of 30 years or more, or vise versa, is an exchange of like-kind property.
EXAMPLES OF NON-QUALIFYING PROPERTY:
1. Property outside of the United States
2. Stock in trade or other property held primarily for sale
3. Stocks, bonds or notes
4. Other securities or evidence of indebtedness or interest
5. Interest in a Partnership
6. Certificates of Trust or beneficial interests
7. Choses in action
As a general rule, the replacement property should be equal or greater in value, (sales price), equity and debt to have a totally tax deferred transaction. In an exchange that qualifies under IRC Section 1031, the exchanger’s realized gain is recognized or currently taxed, only to the extent of the sum of money and the fair market value of “other property” received by the exchanger.
IDENTIFICATION OF REPLACEMENT PROPERTY
One or more replacement properties must be identified within 45 days from the date of the close of the relinquished property. Replacement property must be identified in writing and must be “unambiguously” identified by street address, legal description or distinguishable name. Under the IRC Section 1031 regulations, the exchanger may identify only that number of replacement properties that meet one of the “identification rules”.
A. THREE PROPERTY RULE: A maximum of 3 replacement properties may be identified without regard for fair market value of the properties.
B. TWO HUNDRED PERCENT RULE: Any number of properties may be identified so long as the total fair market value of the identified properties does not exceed 200% of the total fair market value of the relinquished property.
C. NINETY-FIVE PERCENT RULE: Any number of properties may be identified without regard to total fair market value, so long as the exchanger received 95% of the total fair market value of ALL identified properties prior to the expiration of the 180 day exchange period.
To revoke an identified property, the exchanger must notify his qualified intermediary in writing prior to the end of the 45 day identification period. He may identify other replacement properties as long as it is within the 45 day period.
BOOT
In a tax-deferred exchange under IRC Section 1031, anything given or received by the exchanger other than qualifying like-kind property is commonly called “boot”. The concept of boot is not exclusive to Section 1031 exchanges, but is found in other sections of the Internal Revenue Code and can apply to a wide variety of transactions. In the context of Section 1031 exchanges, boot includes property that is expressly excluded from tax-deferred exchange treatment by IRC Section 1031, (e.g. stocks, bonds, choses in action, partnership interests, and inventory). Boot also includes property that otherwise qualifies under Section 1031 but is not like-kind to the property being exchanged in a particular transaction, (e.g. personal property received by the exchanger in an exchange in which the relinquished property is solely real property). Boot can also be cash, notes and mortgages or deeds of trust. The exchanger will be taxed to the extent of the boot he receives.
HOLDING PERIOD
How long must an exchanger hold property in order for it to qualify for tax deferred treatment? One factor in determining whether property has been held for productive use in a trade or business or for investment is the length of time that an exchanger holds it. Although IRC Section 1031 does not specify a minimum holding period, the Internal Revenue Service takes the position that if the relinquished property was acquired immediately before the exchange or if the replacement property is disposed of immediately after the exchange, the exchanger held the property primarily to dispose of it rather than for productive use in a trade or business or for investment. If there are doubts by the exchanger as to whether or not they have held the property a sufficient length of time before the exchange, they should consult with their accountant or tax advisor.
RELATED PARTIES
In the Omnibus Budget Reconciliation Act of 1989, Congress adopted special rules for any exchange between an exchanger and a “related person”.
A Related Person is:
1. The exchanger and a member of the exchanger’s family
2. An individual and a corporation of which more than 50% in value of the outstanding stock is directly or indirectly owned by and for that individual.
3. Two corporations of common ownership or control.
4. An organization qualifying under IRC Section 501, (e.g. an exempt educational or charitable organization) and the person who controls that organization or a member of his family.
5. The fiduciary of a trust and one of the related parties
6. A partnership and the majority owner or two partnerships of common ownership.
EXAMPLE 1: The Exchanger and a related party actually “swap” properties with each other. As long as the Exchanger and the related party hold the respective properties each received from the other for at least two years, without any substantially diminished risk of loss, the exchange works.
EXAMPLE 2: The related party buys the Exchanger’s Relinquished Property and the Exchanger acquires Replacement Property from a third party under the 1031 delayed exchange rules. As long as the related party holds the Relinquished Property and the Exchanger holds the Replacement Property for at least two years, without any substantially diminished risk of loss, the exchange works.
EXAMPLE 3: The Exchanger sells the relinquished property to a third party and acquires Replacement Property from a related party. This exchange does not work even if the exchanger holds the replacement property for more than two years. The exchange is re-characterized as a “swap” between the related parties as shown in example 1. The related party is deemed to have received the relinquished property and to have immediately sold the relinquished property to a third party, thereby not holding the property for the two year required holding period.
An exchanger cannot sell to a third party and buy from a related party and get non-recognition.
Related party transactions need to be approached with a great deal of caution and Exchanger should seek the advice of their CPA or tax advisor.
NOTES IN AN EXCHANGE
In an exchange, there are two points in time when Notes play an important role. The first is when the exchanger is transferring the relinquished property and the second is when acquiring the replacement property. The exchanger must decide whether or not to move the Note through the exchange before transferring the relinquished property to the intermediary.
WHEN THE EXCHANGER WANTS TO KEEP THE NOTE: If the exchanger decides not to use the Note in the exchange, arrangements can be made through escrow to have the Note go directly to the exchanger. If the exchanger is unsure about whether or not to use the Note prior to closing, the intermediary may take the Note as beneficiary and assign their interest to the exchanger at the close of the replacement property should the exchanger decide to keep the Note.
WHEN THE EXCHANGER DOES NOT WANT THE NOTE: If the exchanger decides to keep the Note within the exchange to defer taxes on the Note there are four ways to treat the Note.
(1) Seller of the replacement property accepts the Note as (partial) consideration for the sale of their property.
In this variation, the Note is assigned to the seller of the replacement property at the closing of Phase II by the intermediary. The Note is shown as a credit on the intermediary’s Buyer’s settlement statement and as an exchange credit on the exchange statement.
(2) Find a buyer to purchase the Note.
If a buyer is found, the Note can be assigned to that party prior to the closing on the replacement property. The Note can either be assigned through a closing agent or directly between the intermediary and the party receiving the Note. The Note may need to be discounted to make it “marketable”, depending on a number of factors including position of the Note, collateral, terms and payment history. If the Note is discounted and sold, the amount of the discount is treated for tax purposes as an adjustment to the sales price of the relinquished property. The exchanger needs to determine if the discount will be less than the taxes due on the Note.
(3) The Intermediary receives the full value of the Note prior to purchasing the replacement property.
This often occurs when the parties need to close on the relinquished property and the buyer has not received loan approval, or will receive cash from an outside source during the exchange period. The short term Note is merely a financing technique to help the buyer until their loan is approved or they have more cash. The intermediary will remain the beneficiary only until the Note can be replaced with cash from it’s sale. The greatest risk is the buyer could default on the principal payment and the exchanger would subsequently lose the opportunity to complete the exchange with the cash proceeds represented by the Note.
(4) The exchanger purchases the Note from the intermediary.
If the exchanger is going to buy the Note, it should be purchased at the close of either the relinquished property closing or during the closing of the replacement property. Tax authorities agree the exchanger should purchase the Note for the face value, because unlike a sale to an outside third party, any discount taken by the exchanger could be considered boot. If the exchanger enters into the exchange with every intent to achieve one of these options but fails, the intermediary will assign the Note to the exchanger. Because there was no consideration given for the Note, the face value will be considered boot. However, the exchanger can opt to pay taxes on an installment basis according to the new regulations in Section 1.1031(k)-l(j)(2).
Tax or legal counsel should always be consulted whenever a note is involved in an exchange.
NOTES ON THE REPLACEMENT PROPERTY:
A Note can also become an issue when the exchanger is acquiring property and the seller will carry financing in the form of a Note. The way the Note is treated depends on whether the parties are transferring the property via direct deeding or sequential deeding.
If the property is being deeded directly from the seller to the exchanger, the Note must be directly between the seller and the exchanger. Although enforceable from a legal standpoint, most title companies will not insure the Note if the intermediary is the trustor first, because theyare not in the chain of title. In the states which have recourse laws, the intermediary would prefer the Note to pass directly from the exchanger to the seller.
DEALER STATUS
Property held by a “dealer” will not qualify under IRC Section 1031 property because it is not property held for “productive use in trade or business” or “held for investment”, it is property held for resale.
However, an individual can be both a dealer and an investor in the same type of property. The mere fact that an exchanger’s certificate of incorporation specifies that the corporation was incorporated to buy and sell real property does not prevent that taxpayer from acquiring property and holding it for investment.
The issue of whether the property is held for investment or primarily for sale to customers in the ordinary course of business is a question of fact. Courts look upon the facts and surrounding circumstances of each case. Although a number of factors are considered in making the determination, no single factor is determinative. Multiple property sales of property in a given time or rapid turnover of properties may qualify a person as a dealer without being licensed as such. Where property is held by a dealer, it appears that he can convert the property from dealer property to investment property by permanently abandoning his dealer intent with respect to a portion of the property that he is holding for inventory as dealer property and hold it thereafter for “productive use in trade or business” or for “investment”, thereby qualifying under IRC Section 1031. The dealer seeking to convert “dealer” property may face a difficult issue convincing the IRS that the status of the property has changed. The courts look at frequency of sales of property and the intent of the property owner at the time of acquisition of the property.
1. There must be a reciprocal exchange of “Qualifying-Like Kind” property.
2. There must be the intent to exchange and an Exchange Agreement.
3. The transaction must be structured as an exchange and not a sale.
4. There must not be constructive or real receipt of the exchange funds.
5. Replacement property must be identified within 45 days of the close of the relinquished property.
6. The entire exchange must be completed within the sooner of 180 days from the date of close of the relinquished property or the due date, including extensions, of the filing of the Exchanger’s tax returns for the taxable year in which the transfer of the relinquished property occurs.
QUALIFYING PROPERTY
To qualify for tax deferred treatment under IRC Section 1031, you must reciprocally exchange property which has been held for productive use in a trade or business or held for investment, for “like- kind” property which will be held for productive use in a trade or business or held for investment purposes.
EXAMPLES OF QUALIFYING PROPERTY:
1. Condos
2. Retail Stores
3. Vacant land
4. Ranches
5. Hotels
6. Offices
7. Shopping Centers
8. Apartments / Duplexes
9. Single Family rental
10. Farms
11. Leasehold property with a lease of 30 years or more to run. An exchange of fee title for a leasehold with a remaining term of 30 years or more, or vise versa, is an exchange of like-kind property.
EXAMPLES OF NON-QUALIFYING PROPERTY:
1. Property outside of the United States
2. Stock in trade or other property held primarily for sale
3. Stocks, bonds or notes
4. Other securities or evidence of indebtedness or interest
5. Interest in a Partnership
6. Certificates of Trust or beneficial interests
7. Choses in action
As a general rule, the replacement property should be equal or greater in value, (sales price), equity and debt to have a totally tax deferred transaction. In an exchange that qualifies under IRC Section 1031, the exchanger’s realized gain is recognized or currently taxed, only to the extent of the sum of money and the fair market value of “other property” received by the exchanger.
IDENTIFICATION OF REPLACEMENT PROPERTY
One or more replacement properties must be identified within 45 days from the date of the close of the relinquished property. Replacement property must be identified in writing and must be “unambiguously” identified by street address, legal description or distinguishable name. Under the IRC Section 1031 regulations, the exchanger may identify only that number of replacement properties that meet one of the “identification rules”.
A. THREE PROPERTY RULE: A maximum of 3 replacement properties may be identified without regard for fair market value of the properties.
B. TWO HUNDRED PERCENT RULE: Any number of properties may be identified so long as the total fair market value of the identified properties does not exceed 200% of the total fair market value of the relinquished property.
C. NINETY-FIVE PERCENT RULE: Any number of properties may be identified without regard to total fair market value, so long as the exchanger received 95% of the total fair market value of ALL identified properties prior to the expiration of the 180 day exchange period.
To revoke an identified property, the exchanger must notify his qualified intermediary in writing prior to the end of the 45 day identification period. He may identify other replacement properties as long as it is within the 45 day period.
BOOT
In a tax-deferred exchange under IRC Section 1031, anything given or received by the exchanger other than qualifying like-kind property is commonly called “boot”. The concept of boot is not exclusive to Section 1031 exchanges, but is found in other sections of the Internal Revenue Code and can apply to a wide variety of transactions. In the context of Section 1031 exchanges, boot includes property that is expressly excluded from tax-deferred exchange treatment by IRC Section 1031, (e.g. stocks, bonds, choses in action, partnership interests, and inventory). Boot also includes property that otherwise qualifies under Section 1031 but is not like-kind to the property being exchanged in a particular transaction, (e.g. personal property received by the exchanger in an exchange in which the relinquished property is solely real property). Boot can also be cash, notes and mortgages or deeds of trust. The exchanger will be taxed to the extent of the boot he receives.
HOLDING PERIOD
How long must an exchanger hold property in order for it to qualify for tax deferred treatment? One factor in determining whether property has been held for productive use in a trade or business or for investment is the length of time that an exchanger holds it. Although IRC Section 1031 does not specify a minimum holding period, the Internal Revenue Service takes the position that if the relinquished property was acquired immediately before the exchange or if the replacement property is disposed of immediately after the exchange, the exchanger held the property primarily to dispose of it rather than for productive use in a trade or business or for investment. If there are doubts by the exchanger as to whether or not they have held the property a sufficient length of time before the exchange, they should consult with their accountant or tax advisor.
RELATED PARTIES
In the Omnibus Budget Reconciliation Act of 1989, Congress adopted special rules for any exchange between an exchanger and a “related person”.
A Related Person is:
1. The exchanger and a member of the exchanger’s family
2. An individual and a corporation of which more than 50% in value of the outstanding stock is directly or indirectly owned by and for that individual.
3. Two corporations of common ownership or control.
4. An organization qualifying under IRC Section 501, (e.g. an exempt educational or charitable organization) and the person who controls that organization or a member of his family.
5. The fiduciary of a trust and one of the related parties
6. A partnership and the majority owner or two partnerships of common ownership.
EXAMPLE 1: The Exchanger and a related party actually “swap” properties with each other. As long as the Exchanger and the related party hold the respective properties each received from the other for at least two years, without any substantially diminished risk of loss, the exchange works.
EXAMPLE 2: The related party buys the Exchanger’s Relinquished Property and the Exchanger acquires Replacement Property from a third party under the 1031 delayed exchange rules. As long as the related party holds the Relinquished Property and the Exchanger holds the Replacement Property for at least two years, without any substantially diminished risk of loss, the exchange works.
EXAMPLE 3: The Exchanger sells the relinquished property to a third party and acquires Replacement Property from a related party. This exchange does not work even if the exchanger holds the replacement property for more than two years. The exchange is re-characterized as a “swap” between the related parties as shown in example 1. The related party is deemed to have received the relinquished property and to have immediately sold the relinquished property to a third party, thereby not holding the property for the two year required holding period.
An exchanger cannot sell to a third party and buy from a related party and get non-recognition.
Related party transactions need to be approached with a great deal of caution and Exchanger should seek the advice of their CPA or tax advisor.
NOTES IN AN EXCHANGE
In an exchange, there are two points in time when Notes play an important role. The first is when the exchanger is transferring the relinquished property and the second is when acquiring the replacement property. The exchanger must decide whether or not to move the Note through the exchange before transferring the relinquished property to the intermediary.
WHEN THE EXCHANGER WANTS TO KEEP THE NOTE: If the exchanger decides not to use the Note in the exchange, arrangements can be made through escrow to have the Note go directly to the exchanger. If the exchanger is unsure about whether or not to use the Note prior to closing, the intermediary may take the Note as beneficiary and assign their interest to the exchanger at the close of the replacement property should the exchanger decide to keep the Note.
WHEN THE EXCHANGER DOES NOT WANT THE NOTE: If the exchanger decides to keep the Note within the exchange to defer taxes on the Note there are four ways to treat the Note.
(1) Seller of the replacement property accepts the Note as (partial) consideration for the sale of their property.
In this variation, the Note is assigned to the seller of the replacement property at the closing of Phase II by the intermediary. The Note is shown as a credit on the intermediary’s Buyer’s settlement statement and as an exchange credit on the exchange statement.
(2) Find a buyer to purchase the Note.
If a buyer is found, the Note can be assigned to that party prior to the closing on the replacement property. The Note can either be assigned through a closing agent or directly between the intermediary and the party receiving the Note. The Note may need to be discounted to make it “marketable”, depending on a number of factors including position of the Note, collateral, terms and payment history. If the Note is discounted and sold, the amount of the discount is treated for tax purposes as an adjustment to the sales price of the relinquished property. The exchanger needs to determine if the discount will be less than the taxes due on the Note.
(3) The Intermediary receives the full value of the Note prior to purchasing the replacement property.
This often occurs when the parties need to close on the relinquished property and the buyer has not received loan approval, or will receive cash from an outside source during the exchange period. The short term Note is merely a financing technique to help the buyer until their loan is approved or they have more cash. The intermediary will remain the beneficiary only until the Note can be replaced with cash from it’s sale. The greatest risk is the buyer could default on the principal payment and the exchanger would subsequently lose the opportunity to complete the exchange with the cash proceeds represented by the Note.
(4) The exchanger purchases the Note from the intermediary.
If the exchanger is going to buy the Note, it should be purchased at the close of either the relinquished property closing or during the closing of the replacement property. Tax authorities agree the exchanger should purchase the Note for the face value, because unlike a sale to an outside third party, any discount taken by the exchanger could be considered boot. If the exchanger enters into the exchange with every intent to achieve one of these options but fails, the intermediary will assign the Note to the exchanger. Because there was no consideration given for the Note, the face value will be considered boot. However, the exchanger can opt to pay taxes on an installment basis according to the new regulations in Section 1.1031(k)-l(j)(2).
Tax or legal counsel should always be consulted whenever a note is involved in an exchange.
NOTES ON THE REPLACEMENT PROPERTY:
A Note can also become an issue when the exchanger is acquiring property and the seller will carry financing in the form of a Note. The way the Note is treated depends on whether the parties are transferring the property via direct deeding or sequential deeding.
If the property is being deeded directly from the seller to the exchanger, the Note must be directly between the seller and the exchanger. Although enforceable from a legal standpoint, most title companies will not insure the Note if the intermediary is the trustor first, because theyare not in the chain of title. In the states which have recourse laws, the intermediary would prefer the Note to pass directly from the exchanger to the seller.
DEALER STATUS
Property held by a “dealer” will not qualify under IRC Section 1031 property because it is not property held for “productive use in trade or business” or “held for investment”, it is property held for resale.
However, an individual can be both a dealer and an investor in the same type of property. The mere fact that an exchanger’s certificate of incorporation specifies that the corporation was incorporated to buy and sell real property does not prevent that taxpayer from acquiring property and holding it for investment.
The issue of whether the property is held for investment or primarily for sale to customers in the ordinary course of business is a question of fact. Courts look upon the facts and surrounding circumstances of each case. Although a number of factors are considered in making the determination, no single factor is determinative. Multiple property sales of property in a given time or rapid turnover of properties may qualify a person as a dealer without being licensed as such. Where property is held by a dealer, it appears that he can convert the property from dealer property to investment property by permanently abandoning his dealer intent with respect to a portion of the property that he is holding for inventory as dealer property and hold it thereafter for “productive use in trade or business” or for “investment”, thereby qualifying under IRC Section 1031. The dealer seeking to convert “dealer” property may face a difficult issue convincing the IRS that the status of the property has changed. The courts look at frequency of sales of property and the intent of the property owner at the time of acquisition of the property.
Parameters of an 1031 Exchange
