1031 Tax Deferred Exchange – The Exchange Connection

WASHINGTON STATE LAW, RCW 19.310.040, REQUIRES AN EXCHANGE FACILITATOR TO EITHER MAINTAIN A FIDELITY BOND IN AN AMOUNT OF NOT LESS THAN ONE MILLION DOLLARS THAT PROTECTS CLIENTS AGAINST LOSSES CAUSED BY CRIMINAL ACTS OF THE EXCHANGE FACILITATOR, OR HOLD ALL CLIENT FUNDS IN A QUALIFIED ESCROW ACCOUNT OR QUALIFIED TRUST.  RCW 19.310.040(1)(B) AS AMENDED

I.  IN GENERAL

1.  Property disposed of by the taxpayer (the “Relinquished Property”), must have been held for productive use in trade or business, or for investment, and must be exchanged solely for “like-kind” property to be held either for productive use in trade or business or for investment.  I.R.C. & 1031 (a) (i).

2.  If the taxpayer receives money or other non like-kind property in the exchange (“Boot”) or is relieved of a liability as part of the exchange, (“Mortgage Boot”) the exchange will not qualify for complete nonrecognition of gain but may still qualify for partial nonrecognition treatment.

Common misunderstandings

WRONG:  You must find someone who has property you want and who wants your property in order to complete an Exchange.               

RIGHT:  While the above scenario would certainly qualify as an Exchange, it is truly a rare occurrence.  Today’s Exchange is typically accomplished with a Qualified Intermediary who accepts the Relinquished Property, sells it to a waiting buyer and uses the proceeds to purchase the Replacement Property which is delivered to the Taxpayer.  This must be accomplished in strict compliance with the rules and regulations governing 1031 Exchanges.

WRONG:  The requirement that property be “like-kind” limits the Taxpayer’s investment options.

RIGHT:  The term “like-kind” simply means that real property must be exchanged for real property.  Improved land may be exchanged for unimproved and vise versa, a fee simple interest may be exchanged for an undivided interest in property (eg. 50% undivided interest as a tenant in common), a single property may be exchanged for multiple properties, or vice versa.  A duplex may be exchanged for a fourplex; a single family residence for a condominium; vacant land for an office building, a farm for a shopping center, etc.  Even leases are exchangeable.  However, real property may not be exchanged for personal property.

WRONG: Title to the Relinquished Property must pass simultaneously with the receipt of the title to the Replacement Property.

RIGHT:  By far the most common Exchange today is the Delayed Exchange.  Section 1031 provides that the Taxpayer has 180 days from the transfer (disposal) of the Relinquished Property to acquire the Replacement Property.  This extended time period allows for the realities of real estate transactions which by their nature and the number of parties involved, more often than not experience delays in closing.

WRONG:  Only real estate is eligible for exchange treatment under section 1031.

RIGHT:  Section 1031 applies to all assets used in trade or business or investment purposes.  The definition of “like-kind” is more restricted for personal property but farm equipment, oil and gas equipment, fishing boats, mill equipment, barges, ships, trucks, bulldozers and planes are but a few examples.  Even the furniture and fixtures in business sales are exchangeable.

WRONG:  I can just leave the money with the escrow closer.

RIGHT:  The act of instructing the escrow closer not to give you the money is an act of dominion and control over the proceeds and disqualifies the exchange.  The control of the proceeds must, at all times,  be in the hands of an unrelated third party such as a Qualified Intermediary.

Advantages of an Exchange

  1. Saving tax dollars is a strong incentive, but some non-tax reasons for considering an Exchange are:
    1. Consolidation or diversification of investments;
    2. Exchange of the asset for an asset with greater appreciation or cash flow;
    3. Geographic relocation of assets or elimination of management problems;
    4. Transferring basis between properties and estate planning

Disadvantages of an exchange

  1. The disadvantages of an Exchange include:
    1. Relinquished Property basis carries over to the Replacement Property resulting in a lower depreciable basis in the Replacement Property than if it was purchased outright.
    2. Increased transactional costs.

II. THE TAX REFORM ACT OF 1984

  1. Partnership interests are no longer eligible for Exchange.
  2. Time constraints were provided for non simultaneous or “Delayed” exchanges.
    1. Replacement Property must be identified within 45 days.
    2. Replacement Property must be acquired within the earlier of 180 days or the due date of the Taxpayer’s federal income tax return (including extensions).
  3. The final regulations of April 25, 1991 established the identification process and provided safe  harbors by using a Qualified Intermediary.

III.  TECHNICAL REQUIREMENTS 

  1. Section 1031 (a) (1) provides that: “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.” Note that this provision in mandatory, not elective.
  2. Property not “exchangeable” is “Stock in Trade” and property held “Primarily for sale” (inventory); Stock, bonds, or notes; partnership interests; Certificates of trust or beneficial interest; Choses in action.
  3. Stock in trade is property considered as inventory to a dealer of that type of property.  Real property held as inventory does not qualify for Exchange under Section 1031 (a). Nothing however, prevents a dealer from holding specific assets either for productive use in trade or business or for investment. Factors to be considered in identifying stock in trade are, the purpose for which the property was initially acquired and subsequently held; the extent improvements were made to the property; the frequency, number and continuity of sales; the extent and nature of the transaction involved; the business of the taxpayer; the extent of advertising used in soliciting buyers; the listing of the property; and the purpose for which the property was held at the time of sale.

IV.  THE LIKE-KIND REQUIREMENT

  1. Personal property is not of like-kind with real property.   Whether property is real property or personal property is determined by state law. State laws may vary and may affect the exchange of mobile homes and timber.  You should also be aware of this provision and should look clsoly at what is being transferred when exchanging farms, apartment buildings, businesses, etc.  For example is irrigation equipment on a farm part of the real property or is it personal property, what about the well head and pump?  A leasehold with 30 years or more to run is like-kind with real estate in fee. In other words a 30 year lease can be exchanged for deeded property. Leases of less than 30 years while not “like-kind” with fee interests in land are exchangeable for other leases of less than 30 years.
  2. When an Relinquished Property is partially held for investment, and partly held for personal use, allocation of value between the two types of properties becomes important.  A common example is when the Taxpayer owns a duplex, occupying one of the units as a personal residence, and rents the other unit. The allocation of value could be based on the number of units (50/50), their respective square footage, the nature to the interior improvements views etc., or by appraisal.  Any reasonable allocation is permissible but be sure to document it at the time of the exchange and to the extent possible have the value determined by a third party.
  3. A tenancy in common interest is like-kind with a full fee interest.  For example, you can exchange a rental house you own for a percentage interest in a shopping center.  However, make absolutely certain that you are receiving a tenancy in common interest in real property and not a partnership interest.
  4. A single property is like-kind with multiple properties.  For example a duplex can be exchanged for three single family residential rental houses or vice versa.  This concept can be quite useful in the estate planning area.

FOR MORE INFORMATION ON 1031 EXCHANGES CONTACT OUR OFFICE