Property exchanging can be a key element in developing an investment strategy. There are some very important terms used when describing all the aspects of tax deferred exchanges. We have provided a brief glossary of some of these important terms at the end of this tip sheet.
Internal Revenue Code Section 1031 identifies the rules under which “investment type real estate can be exchanged for “like kind” property and defer the payment of capital gain taxes. While sometimes referred to as a “tax free” exchange, such words are a misnomer. Such a transaction merely “defers tax” by transferring the taxpayer’s old “cost basis” to a newly acquired property. When this newly acquired property is in turn transferred, the full tax generated from both transfers will become due unless the latter transfer is also structured as a tax deferred exchange. The true power of exchanging is its ability to meet investment objectives without losing equity to taxation.
It is important to understand that the 1031 exchange rules do not apply to one’s personal residence. More recent tax reform resulted in significant change in the ability to claim tax free home profits in the sale of a personal residence. Rules for the exchange of investment property via the 1031 section of the tax code have not been liberalized.
While most exchange transactions today are conducted on a “Starker delayed exchange” basis, prior to 1979 an exchange was required to be a “simultaneous” exchange. A “concurrent” or “simultaneous” exchange is when both properties (the relinquished and replacement properties) are ready to close escrow and record the change of title the same day.
Now, the majority of exchanges are conducted via a professionally “qualified intermediary” (also known as an accommodator or facilitator) as it is the only safe way to conduct an exchange today. This third party becomes a part of the exchange agreement who acquires title to the property for the sole purpose of accommodating or facilitating the exchanger. It is critical that the sale proceeds from the relinquished property be held beyond the exchanger’s constructive receipt by a third party intermediary. If the exchanger were to have access to the funds, tax consequences could result.
To make a completely tax-deferred trade, the cost of the rental or investment property acquired must equal or exceed the sales price of the relinquished property. Any consideration (i.e.; cash, notes, personal property or debt relief) received from the relinquished property sale is known as “boot” and is taxable.
The “delayed exchange” rules have been revised several times. In 1991, the regulations defining the identification requirements were enacted. The trickiest portion of the exchange process now can be making certain that the required time periods are adhered too. The “exchange period” begins on the date the taxpayer transfers the relinquished property (closes escrow) and ends at midnight on the earliest of the 180th day thereafter OR the due date (including extensions) for the taxpayer’s tax return for the taxable year in which the transfer of the relinquished property occurs. Depending upon the time of year in which the exchange occurs, the exchanger may not have the full 180 day period in which to consummate the transaction.
Perhaps the more critical time period is the “identification” period. This period begins on the date the taxpayer transfers the relinquished property to the intermediary and ends at midnight on the 45th day thereafter. The taxpayer must find and notify the intermediary in writing of the replacement property to be received on or before the 45th day following the close of escrow on the relinquished property.
The property must be unambiguously described (generally a legal description or street address will suffice) and designated as replacement property in a written document signed by the taxpayer. Identification of the replacement property in the actual contract between the parties fulfills this requirement. Under most circumstances, no more than three potential replacement properties may be designated and total value requirements of the multiple designated properties prevail. Counsel is advised if more than one replacement property is to be identified.
GLOSSARY OF EXCHANGE TERMS
BASIS or COST BASIS: Typically refers to the purchase price of the property when acquired by the exchanger, plus the cost of improvements and less any depreciation taken. The cost basis will thereafter serve as a base figure in determining gain or loss and can be transferred to other property via the tax deferred exchange process.
ADJUSTED COST BASIS: The cost basis with additions (i.e.; improvements) and subtractions (i.e.; depreciation) which subsequently becomes the value ascribed to the newly acquired property and from which future gain or loss is calculated
BOOT: The term used to describe unlike property received via the exchange. Cash, notes, personal property, reduction in mortgage (called debt relief) are all examples of “boot” and subject to tax. To avoid boot, an exchanger must trade across or up in tow areas . . . equity and mortgage amount.
LIKE KIND PROPERTY: Refers to the nature or character of the property. Another way to describe eligible exchange property is the words “real for real” . . . meaning that real property must be exchanged for other real property and cannot be exchanged for personal property. Under this definition, a rental home can be exchanged for another rental home, multiple units, apartment complex, commercial property or unimproved property (land).
RELINQUISHED PROPERTY: The property that is being given up by the exchanger, sometimes referred to as the “down-leg” property.
REPLACEMENT PROPERTY: The property acquired by the exchanger in an exchange, sometimes referred to as the “up-leg” property.