Different Types of 1031 Exchanges
1031 Exchange Forward Delayed
The most common type of exchange, the Forward Delayed Exchange, happens when an investment property is sold and another property is purchased within 180 days following the sale of the relinquished property. For a safe harbor Forward Delayed Exchange, the sale proceeds must be held by a Qualified Intermediary between the sale of the relinquished property and the closing on the replacement property.
Simultaneous 1031 Exchange
A simultaneous 1031 Exchange occurs when two or more properties are exchanged simultaneously. This can happen when two properties are swapped, property for property, which is called a two-party exchange. This can also happen when a property is sold and the replacement property is purchased simultaneously. To ensure safe harbor protection, a Qualified Intermediary should facilitate the exchange, to avoid tax consequence.
Reverse 1031 Exchange
In a Reverse 1031 Exchange, the replacement property is purchased before the sale of the relinquished property. The replacement property must be held by an Exchange Accommodation Title Holder until the sale of the relinquished property, which must take place within 180 days following the purchase of the replacement property. Due to its complexity, a Reverse 1031Exchange incurs higher fees.
1031 Construction Exchange
Construction Exchanges, or Build-to-Suit Exchanges, occur when the principal uses the funds from the sale of the relinquished property to construct improvements on the replacement property. The property on which the improvements are constructed cannot be held by the taxpayer and must be held by a third party called an Exchange Accommodation Title Holder until either the improvements are complete or until the end of the 180 Exchange Period, after which the title holder is deeded the Replacement Property with the improvements. Due to its complexity, a Construction Exchange incurs higher fees. Also your tax basis is based on the improved value after improvements.
Dealing with Seller Financing
Most investors understand the tax benefit of structuring a 1031 exchange, whereby an investor trades one property for another without having to pay capital gains taxes. In an ordinary sale transaction, the investor is taxed on any gain realized by the sale of the property. But in an exchange, the tax on the transaction is deferred until some time in the future. In an exchange the investor, instead of receiving cash from the sale of their investment property, assigns his or her rights to the old relinquished property sale proceeds to a Qualified Intermediary (QI). From the date of closing the relinquished property, the QI holds the funds in a qualified exchange account while the investor must identify new replacement property within 45 days. Then, within 180 days of closing the relinquished property (Exchange Period) the QI funds the purchase of the new replacement property to complete the exchange.
In some cases, investors will carry back a Note instead of cash as consideration from the buyer. However, investors should be aware of the “like-kind” requirement in a 1031 exchange, meaning that an investor may only receive property that is “like-kind” in nature and character to the property that was sold. Thus, an investor who sells real property is only allowed to receive real property in exchange. If an investor receives a Note or cash in an exchange of real property, this does not meet the like-kind requirement and the investor will be liable for capital gains taxes for the Note or cash received.
Where an investor is considering financing the buyer’s purchase of the relinquished property and the investor had planned to structure a 1031 exchange, an investor should consider the following options:
• The investor may take back a Note for all or part of the buyer’s purchase price; the investor qualifi es for installment sale treatment on the Note, which in effect spreads the taxation of the gain over the life of the Note.
• Include the Note as part of the exchange by naming the QI as payee of Note and benefi ciary of deed of Trust/Mortgage. The QI may either: Assign the Note to the Seller of the Replacement Property as partial payment towards the purchase price; or sell the Note to third party for cash. The cash proceeds are added to the existing qualified exchange account; or sell the Note to the investor for cash during the exchange period and use the Note proceeds towards the replacement property purchase.
If the investor is unable to locate a purchaser for the Note by the end of the exchange period, the QI will assign the Note to the investor and the investor will be liable for any capital gains taxes due on the Note. The investor qualifies for the installment sale treatment for the life of the Note.
By Michelle Rojas and Rosa Esqueda of LandAmerica 1031 Exchange Company.
This content is general in nature and should not be acted upon without further guidance from your own tax counsel. (10/06 RE)
Having Trouble Finding Quality Property to Identify?
Consider a TIC Investment!More often than not, an exchange will fail due to the taxpayer’s inability to identify property. Planning is said to be the key to a successful 1031 exchange. However, even with the best planning, the 45th day arrives and the taxpayer is searching at the last minute in an attempt to find quality property to identify. After all, 45 days is a short period of time to make an investment decision.
Did the investor consider a TIC?
A Tenant In Common (TIC) interest is an undivided fractional interest in real estate. TIC products available include large office buildings, retail shopping centers, warehouses, apartment buildings, and single tenant retail all of which are typically recognized as institutional-quality commercial real estate. A TIC interest has a number of advantages, but the foremost advantage is that it allows an investor to acquire investment property otherwise out of reach.
Rather than owning 100% of the property, the investor is able to own a mere 5%, for example. Another great benefit of the TIC ownership is the ability to diversify the investment into more than one property without the hassles of dealing with tenants, maintaining facilities, paying property taxes, etc. Most importantly, it provides an increased opportunity to identify replacement property within the required 45-day period.
The Internal Revenue Service issued Revenue Procedure 2002-22 establishing guidelines used to determine when a TIC interest would be considered an interest in real estate for 1031 purposes. Prior to the Rev. Proc., there remained the difficult question of whether the co-ownership of property constituted an ownership interest in a business entity, which does not qualify for a 1031 exchange. The resulting guidelines opened the door for 1031 exchange investors. It is with these guidelines that the TIC industry has flourished, growing exponentially each year. Sponsors of TIC programs are able to structure investment programs to comply with the general guidelines set forth in Rev. Proc. 2002-22, and are able to provide alternative replacement property products to taxpayers. There are significant restrictions in place in order for a TIC interest to qualify for 1031 treatment, including a limitation on the total number of co-owners in a property (35), mandatory unanimous consent by all co-owners on property management, financing and disposition issues. There are also significant restrictions on exit strategies for the co-owners. TICs have already gained tremendous momentum in the marketplace. Rev. Proc. 2002-22 fueled a dramatic increase in TIC investments. TIC equity volume exploded to $1.8 billion in 2004 compared with just $167 million in 2001, a 978 percent increase. More than $4 billion in equity was invested in 2005, based on information presented at the 2005 Tenant-in-Common Association (TICA) Symposium. If you or your client is having difficulty locating quality replacement property, consider the TIC interest. It could be just the type of product to fi t your investment portfolio.
By Susanne Haines and Rosa Esqueda of LandAmerica 1031 Exchange Company.
This content is general in nature and should not be acted upon without further guidance from your own tax counsel. (10/06 RE)
