Julian Munoz Realtor
What is a 1031 Tax Exchange?
Purpose of a 1031 Exchanges...
The purpose of Section 1031 of the Internal Revenue Code is to allow the investor to defer the taxes on the appreciation of capital normally recognized on the sale of real property. These taxes may be deferred if the property was held for investment or productive use in a business or trade and is exchanged for like-kind properties under certain conditions including: That the exchanger not have constructive use of the funds until the exchange is completed and that the transaction is completed within specific time frames.
Frequently people ask what services the facilitator provides. As every transaction is different the services vary. The listed services are included in every exchange and included in the fee which is charged only after the initial closing.
Consult with Exchanger. The facilitator is available for unlimited contacts and is available to answer questions by phone or in person concerning the structure, benefits, and disadvantages of tax-deferred exchanges.
Coordinate with REAL ESTATE AGENT. Review the process and concepts with the agent and assist in coordinating all aspects of the sales process, including providing the verbiage for listing and Purchase and Sale Agreements.
Coordinate with Tax Advisor. Each exchanger should have his or her own personal tax advisor, CPA, or Enrolled Agent. That person will be there to assist the exchanger in completing the forms, to calculate the basis and depreciation schedule for future tax filings, and to advise the exchanger as to whether an exchange is appropriate.
Review title report. The facilitator will work with the title company to assure that ownership is held properly for an exchange, to advise the exchanger of any problems, and to review the history of the property concerning former uses and ownership which may cause future problems.
Coordinate with Escrow Officer. Provide Escrow Instructions, Assignments, and Facilitator Agreements to the escrow officers and coordinate closing activities with them.
Consult with other parties. Work with other interested parties, including loan companies, county and state tax offices, CPA's, attorneys, bankers, friends, and relatives at the request of the exchanger.
Hold funds in trust account. All funds are held in a trust account within the state of Washington. They are held in accordance with the regulations in IRC 1031, available for immediate closing, but restricted from use of or pledge by the exchanger.
The same steps and services are provided for each property transaction involving a RELINQUISHED property and repeated for each REPLACEMENT property.
Because exchanges usually involve slightly greater costs than sales, and you are carrying forward a lower depreciation schedule, not every transaction should be an exchange.
To calculate your taxable gain add the original purchase price with capitalized closing costs to any improvements you have made. Subtract accumulated depreciation to determine the adjusted cost basis of your property. Subtract this adjusted cost basis and your one-time closing costs from the selling price to determine your capital gain.
Original cost $ 50,000
Capitalized closing costs 1,000
Less Accumulated Depreciation 10,000
Adjusted Cost Basis 50,000
Selling Price 150,000
Less Selling costs 15,000
Net Selling Price 135,000
Less Adjusted cost Basis 50,000
Capital Gains Tax Bracket 20%
Taxes Due on Sale 17,000
Mortgage Payable 30,000
Equity Before Tax 105,000
Equity After Tax $ 88,000
If your goal includes investing in real estate, the paying of taxes when they could be deferred constitutes an Opportunity Cost. Tax deferral amounts to an interest-free loan from the government.
IRC 1031: The Section of the Internal Revenue Code which specifies the terms and conditions under which the taxpayer may exchange certain types of property without recognition of capital gains taxes.
Exchanger: The taxpayer who has property which has appreciated in value which he wishes to exchange for other like-kind property and defer any capital gains taxes.
Like-Kind Property: Almost any real property (land and/or land with buildings) which is non-owner occupied.
Boot: Any un-like property received in an exchange, such as cash or mortgage relief in excess of the new mortgage.
Identification: The exchanger must transmit within 45 day of the closing of the relinquished property up to three potential replacement properties. Identification must be specific addresses or legal descriptions with any improvements detailed as clearly as possible.
Exchange Period: The exchanger has 180 calendar days in which to complete the entire exchange.
Facilitator: The company or individual who acts as a straw man in relinquishing the old property and acquiring the new properties, holds the funds, and ties the two transactions together.
Relinquished: The property held by the exchanger which he wishes to give up in the exchange for new property.
Replacement: The property to be acquired in the exchange. Any number of properties may be exchanged for any number of properties.
Mortgage Relief: Mortgage given-up or paid off on the property relinquished.
Mortgage Acquired: Mortgage assumed or taken to acquire the replacement property.
Delayed Exchange: When the old property is sold before the new property is acquired.
Simultaneous Exchange: When both relinquished and acquired properties close the same day.
Improvement Exchange: When the replacement property includes buildings to be built, or other improvements to be completed as part of the exchange. Usually done to balance the values of the acquired property with the relinquished property.
Equal or Greater Value: The replacement property must be of equal or greater net fair market value for the exchange to be fully tax-deferred.
Net Fair Market Value: The selling price of the property less all closing costs.
Adjusted Cost Basis: The cost of the property plus capital improvements, less depreciation and capital losses.
Capital Gain: The difference in value between the adjusted cost basis and the net selling price, not the amount of cash received.
Reverse Exchanges: When the exchanger acquires replacement property prior to closing on the relinquished property. This has never been approved by the IRS or adjudicated in court.
Capital Gains Taxes: Taxes due on the gain resulting from the sale of any capital asset. Calculated at the taxpayers ordinary tax rate, up to a maximum of 28%.
Addendum to Earnest Money Receipt & Agreement...
The following terms and conditions are part of the Earnest Money Receipt and Agreement dated ____________, 199__, between __________________("Seller") and _________________("Purchaser").
CHECK ONLY ONE
PURCHASERS CHOICE TO DO _1031 TAX EXCHANGE:
SELLERS ARE AWARE THAT BUYERS AND/OR ASSIGNS(1031 Exchange Coordinators, Inc.) ARE ATTEMPTING TO QUALIFY FOR A TAX DEFERRED EXCHANGE AND SELLER AGREES TO COOPERATE WITH BUYER AND SIGN ALL SUCH DOCUMENTATION REASONABLY NECESSARY TO ACCOMPLISH THE EXCHANGE PROVIDED THE SELLER INCURS NO ADDITIONAL COST OR LIABILITY.
SELLERS CHOICE TO DO _1031 TAX EXCHANGE:
PURCHASERS ARE AWARE THAT SELLERS AND OR ASSIGNS (1031 Exchange Coordinators, Inc.) ARE ATTEMPTING TO QUALIFY FOR A TAX DEFERRED EXCHANGE AND PURCHASERS AGREE TO COOPERATE AND SIGN ALL DOCUMENTS REASONABLY NECESSARY TO ACCOMPLISH THE EXCHANGE PROVIDED THE PURCHASER INCURS NO ADDITIONAL EXPENSE OR LIABILITY.
Neither the agent nor the broker has made any representations as to the terms, structure, or conditions of this contract with regard to the effect it may have on the qualification for tax deferral under I.R.S. Code, Section 1031. All parties have been advised to seek expert council of their own choosing should they have any questions concerning the legal or tax implications of the exchange transaction.
Federal Code Of the United States of America Section 19 IRC 1031. Exchange of property held for productive use or investment.
(a) Nonrecognition of gain or loss from exchanges solely in kind.
(1) In general. No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
(2) Exception. This subsection shall not apply to any exchange of --
(A) stock in trade or other property held primarily for sale,
(B) stocks, bonds or notes
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.
(3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property. For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if --
(A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
(B) such property is received after the earlier of --
(i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
(ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.
(b) Gain from exchanges not solely in kind.
If an exchange would be within the provisions of subsection (a). of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(c) Loss from exchanges not solely in kind.
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.
If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed a liability of the taxpayer or acquired from the taxpayer property subject to a liability, such assumption or acquisition (in the amount of the liability) shall be considered as money received by the taxpayer on the exchange.
(e) Exchanges of livestock of different sexes.
For purposes of this section, livestock of different sexes are not property of a like kind.
(f) Special rules for exchanges between related persons.
(1) In general. If --
(A) a taxpayer exchanges property with a related person,
(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and
(C) before the date 2 years after the date of the last transfer which was part of such exchange-- (i) the related person disposes of such property, or (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph occurs.
(2) Certain dispositions not taken into account. For purposes of paragraph (1)(C), there shall not be taken into account any disposition --
(A) after the earlier of the death of the taxpayer or the death of the related person,
(B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or
(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.
(3) Related person. For purposes of this subsection, the term "related person" means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).
(4) Treatment of certain transactions. This section shall not apply to any exchange which is part of a transaction (or series of transactions)structured to avoid the purposes of this subsection.
(g) Special rule where substantial diminution of risk.
(1) In general. If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period.
(2) Property to which subsection applies. This paragraph shall apply to any property for any period during which the holder's risk of loss with respect to such property, is substantially diminished by --
(A) the holding of a put with respect to such property,
(B) the holding by another person of a right to acquire such property, or
(C) a short sale or any other transaction.
(h) Special rule for foreign real property.
For purposes of this section, real property located in the United States and real property located outside the United States are not property of a like kind.
*The above information is deemed reliable but please check with your facilitator before implementing.