INTRODUCTION
Mr. Velarde has been an attorney since 1978 and graduated from the University of Washington's School of Law. He is also a licensed Real Estate Broker. Mr. Velarde has extensive knowledge and experience with real estate tax-deferred exchanging and has taught this subject as a college professor and in state-approved courses taken by thousands of real estate brokers, agents and attorneys. He is also licensed to practice law in the District of Columbia, New York State, Washington State and the U.S. Tax Court
Much has been written over the years to explain tax deferred exchanges,
however, it has been my experience that most explanations are lengthy
and much too technical. Being a well known real estate attorney with an
emphasis in tax deferred exchanges, as well as an author on this subject,
it has been brought to my attention that a simple to read guide explaining
tax-deferred exchanges has been in high demand for quite a long time.
We hope this guide will be useful to you.
To begin with, I am often asked, "Why should I consider a tax-deferred exchange?" Well, there are various reasons why one would do a tax-deferred exchange, the following are a few examples:
You may have some non-income producing real estate investments, such as raw land, which are not giving you any cash flow. You could exchange this for property that is income producing, such as a duplex or a rental home. Not only could you start realizing a cash flow, but you can also get income tax deductions such as depreciation, which you did not have with your raw land.
1. The best advise I can give you is to USE EXPERTS!! It is too easy to make a mistake and lose your tax deferral. Improperly documented exchanges, even if you state your intentions in writing, have led to numerous DISALLOWED EXCHANGES by the IRS. Missing the 45 day or 180 day rule deadlines will cause the entire exchange to be DISALLOWED! The penalties are severe! The IRS can assess the back taxes owed with a 25% PENALTY, and all at 20% INTEREST. A $ 10,000 tax owed could add up to a total of $ 17,500 due in two years when you get audited.
2. The IRS strongly believes in substance over intention. In other words, you must prove your intentions of doing an exchange, in writing, each step of the way. The IRS requires that you use either a "Qualified Intermediary" or "Qualified Escrow Accounts" (where the buyer of your property will buy the replacement property for you), or a "Qualified Trust" (where you hire a Trustee to hold the buyers money and acquire the replacement property for you).
3. Often people find that they have been holding properties long after their appreciation has topped out. You can start rebuilding your equity by disposing of those properties and acquiring new ones.
4. The area your rental properties are located in has become economically depressed or is deteriorating. Why not trade those properties for others in a better location or neighborhood?
5. If you have rental properties with problem tenants or they are in need of expensive maintenance or repairs, sell the properties and acquire other rentals with fewer problems. This may also give you an increase in appreciation.
6. Many people think about selling and reinvesting into more income or investment property. One would be foolish not to do a tax-deferred exchange! If you sell and reinvest, you will pay income taxes on the realized gain. However, if you call it an exchange, you will pay no taxes. This means that more money is available as leverage for acquiring your next properties. Look at it as a free loan from the government!
7. With proper estate planning you can keep exchanging properties throughout your lifetime. Neither you nor your heirs will ever pay income taxes on the gains.
8. By doing a tax-deferred exchange, you can conserve your equity by not having to pay taxes on your net profits.
TAXES
When you sell real estate which has been held for investment or for business, we all know that a large amount of income taxes will need to be paid. Even if you reinvest all of the money from your sale into more real estate, you will still pay nearly the same amount in income taxes
EXCHANGES
In most of our minds the question lies, "what do the big boys do?? If all of the tax loop holes are for the rich, well, what can the average taxpayer do??" OK, here is the answer we've all been looking for! If you arrange for the sale of your business or investment properties as an "Exchange", such as "trade" properties so to speak, and then reinvest all of the money from your sale into buying more business or investment properties, you will pay NO INCOME TAXES! Yes, its true!
Also, your income taxes are actually deferred (postponed) until the day you decide to outright sell your property and pocket the sales proceeds. You can even avoid "ever" having to pay the income taxes at all by continuing to exchange properties throughout your entire lifetime! Then, with proper estate planning, you can pass it all to your heirs completely TAX-FREE!!
DISADVANTAGES
There are only two possible disadvantages worth noting. One of them being that you will have a slightly lower depreciation schedule when you acquire your new properties. This is because the IRS will look at your new tax basis as being the same as your previous one; less your deferred gain.
The other disadvantage is that losses on your income tax return cannot be deducted if you exchange property rather than sell it. So, if you want to take a loss, just call it a sale, not an exchange
LEGAL & ETHICAL
Tax-deferred real estate exchanges are legal and ethical. Internal Revenue Code Section 1031 has been in existence since 1928. The IRS has even established "recent" guidelines for accomplishing tax-deferred exchanges! The purpose for this law has been to encourage real estate sales nationwide which, in turn, supports our entire economy.
WHAT PROPERTIES QUALIFY
In this area, confusion often sets in. Put very simply, any type of real estate used for business, trade or investment purposes will qualify. Examples are: apartments, office buildings, multiplexes, single family or condo rentals, raw land, farms, ranches, commercial, and industrial. All of these will qualify! A lot adjoining a primary residence can also qualify if it is considered investment property.
MIX & MATCH: You are not limited to exchanging for property similar or exactly like your present property. The law and the IRS allows you to trade raw land for an apartment building or a commercial mall, or a condo rental as long as you structure it as an exchange. As long as you are selling (wanting to exchange) real property used for business, trade or investment purposes; you can buy (exchange it for) any other type of business, trade or investment properties. For example, you can sell your self-operated gas station (trade property) and buy an apartment building (business property) and pay no taxes!
WHAT PROPERTIES DON'T QUALIFY
Now it is time to talk about IRC Section 1034.
This law is in regards to your "personal" residence. The home
you live in will not qualify for an exchange because you cannot mix IRC
Sections 1031 with 1034. In other words, you cannot sell your home and
use the proceeds to buy business or investment property. Nor can you sell
business or investment property and buy a primary residence that you intend
to live in shortly after acquiring it. Exceptions and loopholes do exist,
and will be discussed later.
But for now, remember, that all of the properties you sell and buy in an exchange must be trade, business or investment related
YOU DON'T HAVE TO SWAP
You do not have to buy property at the same time you are selling. The law allows for what is called a "Delayed Exchange". This lets you sell now and buy your "replacement" property at a later time. However, the law does set up some strict timing requirements which will be explained later.
There are some interesting ways you can plan your exchange. For instance, you can sell your property to one party and buy your replacement property from another. You can sell one property and buy two, three or more replacements! Here is a good example: if you sell a $450,000 waterfront lot you can buy a $50,000 condo rental, a $100,000 parcel of raw land as an investment, a $150,000 duplex, and a $200,000 commercial building, and
PAY NO TAXES!
Also, you can sell several properties and buy only one property with the sales proceeds. In this instance, you may sell a triplex, a rental single family home and acreage for $400,000 and buy an office building for $500,000 and still pay no income taxes!
DO DEALERS QUALIFY?
A "dealer" is a person, corporation, or entity that acquires property for a fast resale only. They are similar to "used car dealers" who buy cars to quickly repair, clean and polish them for resale. Congress limited exchanges to those properties "held for productive use in a trade or business or for investment". The IRS interpreted those words to exclude properties "held primarily for sale". Therefore, if a dealer or anyone else tries to exchange property held primarily for sale, they cannot exchange.
However, if a dealer decides to rent the property or to hold onto the property long enough to be considered investment property, then the property can be exchanged.
HOW TO HAVE A TOTALLY TAX FREE EXCHANGE
For you folks who like rules and formulas, this section is for you! For those of us that don't, we will keep it simple. So, here it goes... when you sell your property(s), the replacement property(s) must equal or be greater than the VALUE (sale price) and existing DEBT of the property(s) being sold (exchanged), and all of your EQUITY from the property you are selling (exchanging) must go into acquiring the replacement property(s).
The formula is: The replacement property(s) must be equal or greater in VALUE & DEBT than the property(s) being sold (exchanged).
PARTIAL TAX FREE EXCHANGE
Sometimes you may have a PARTIAL TAX-DEFERRED EXCHANGE. This may happen in a number of ways. Such as pocketing some cash from the sale, or receiving "nonlike-kind" property in the exchange. This "non-like-kind" property could be personal property or any other kind of property different from real estate. Another way to have a partial tax-deferred exchange would be for your replacement property to not be equal to or greater than either the VALUE or DEBT of the property you sold. This means that you will pay some income taxes.
Any one of the above situations is known as a "PARTIAL TAX-DEFERRED EXCHANGE" because you have not protected all of your sales proceeds from being taxed. For example, if you sell a $200,000 rental and buy two properties totaling $150,000, you may pay income taxes on the $50,000 difference.
Another example would be if you owned acreage worth $200,000, in which you had $100,000 in DEBT. You decide to sell it!
You then buy a $200,000 duplex using a $50,000 loan (which gives you a $50,000 in equity). This means you went down in debt by $50,000 which is taxable income. Remember, for a totally tax deferred exchange, you must aquire replacement property(s) which are EQUAL to or GREATER in sales price (VALUE) "and" EQUAL to or GREATER in DEBT than the properties being sold.
COMMON EXCHANGE SITUATIONS
As much as I would like to, it is difficult to anticipate all of the situations which may involve an exchange and discuss them at length. So, I will comment on some of the most common ones which may prove to be most helpful to you.
PROPERTIES UNDER CONSTRUCTION
You can acquire replacement properties that will be built for you. However, the construction project must be at a point for all of your equity to be used up and the fair market value equal to the sales price of the property(s) you sold when you acquire title. Completion of the construction project out of your own funds after title passes to you is acceptable.
Although it is not built, during the 45 day identification period, you must identify this property in as much detail as possible. Also, at the time of acquisition, the construction project must be substantially the same as it was at the time you identified it in detail. Only "usual or typical" construction changes will be allowed.
PARTNERSHIPS
A partnership can sell real estate it owns and exchange it for more real estate if it takes title to the replacement property in the name of the partnership. For example, "ABC Ltd. Partnership" is the seller and the replacement property is sold to "ABC Ltd. Partnership". However, if the partnership only wants to sell a portion, such as the sale of "25% interest in ABC Ltd." which owns a building, this would be unacceptable and the IRS will DISALLOW the exchange.
What if one or more members of a partnership wish to do an exchange and the other members do not? Well, although it sounds difficult, there is a way to accomplish a totally tax-deferred exchange. However, it would take too much space to explain it here. Buy my book and read the chapter on partnerships.
SELLER FINANCING
Typically when the real-estate market softens, making it harder to sell, sellers often finance the purchasers themselves. THIS IS DANGEROUS!! Since the purpose of exchanging is to sell and roll over some or all of the sales proceeds into replacement property, any money pocketed is TAXABLE as a partial tax-deferred exchange (as we discussed earlier).
Unless the seller of the replacement property is willing to take over your promissory note (with a Deed of Trust) or Real Estate Contract you received from your buyer; the payments will go directly to you as TAXABLE INCOME. So you may want to compare the tax savings of waiting for an all cash buyer and do a total tax-deferred exchange, compared with the taxes you would pay on an installment sale (which is what seller financing is). Read my book to see other ways around this problem
CONSTRUCTIVE RECEIPT
If there is a way to foul up your exchange and end up having to pay taxes unnecessarily, this is where it usually happens. For instance, if you or one of your agents (real estate agent or any other person working in your behalf), directly or indirectly, exerts any control over the money received from your sale before the entire exchange is completed, the IRS will DISALLOW THE ENTIRE EXCHANGE.
The object of an exchange is to keep you away from the money until you have acquired all of your replacement properties. If your attorney, CPA, real estate broker, escrow officer, or an employee touches the money; in the eyes of the IRS, it is as good as being in your pocket!! This is why you must hire a stranger to act as a "Facilitator", or "Qualified Intermediary" or "Trustee" to handle the exchange.
The IRS will consider any one who has an existing "AGENCY" or "Fiduciary" relationship with you as being under your control, which in turn, means your money being under your control also. Most state laws automatically consider an escrow officer or closing agent as being your agent, so you cannot use them to hold your money (i.e., hold the proceeds from your sale until you need it to acquire the replacement property).
ESTABLISHING INTENT
It is important to document your intention to do an exchange as soon as you can and it MUST BE IN WRITING. You can establish your written intent in the Listing Agreement with a real estate office; and/or in the Earnest Money Agreement with your buyer. This can be done at the time of negotiation, or later as an addendum to the Earnest Money Agreement sometime before closing takes place.
I recommend using the language in my book which obligates the buyer and seller to cooperate with your exchange at no extra cost or liabilities to them
TIMING REQUIREMENTS
We must pay careful attention to the timing rules set up by the IRS. When you sell your property(s) and title passes to the purchaser, the timing requirements to IDENTIFY (locate) and ACQUIRE your replacement property(s) begins. You will have 45 days to produce a written list of up to 3 potential replacement properties (common addresses are OK) delivered to your Facilitator or anyone else that is not your '"agent".
A signed, dated Earnest Money Agreement is an acceptable alternative to the written list. If you wish to identify more than 3 potential replacement properties, there are only 2 ways to do this:
1. 200 PERCENT RULE: You can identify more than 3 properties if all of them add up to no more than TWICE the sales price (fair market value) of the property(s) you sold; or
2. 95% RULE: You can identify as many properties as you wish AS LONG AS 95% of the fair market value of all property(s) identified are actually acquired. In other words, if you identify 5 properties worth a total of $100,000 you had better acquire at least $95,000 worth from that list.
3. 180 DAY RULE: You must ACQUIRE your replacement properties within the EARLIER of 180 days from closing of the first sale, or, the DUE DATE FOR THE TAX RETURN (including extensions) for the year of the sale.
WARNING!! If you fail to properly and timely identify your potential replacement properties, or fail to acquire title to all of the replacement properties in time, the IRS could DISALLOW YOUR ENTIRE EXCHANGE
SUMMARY OF SECTION 1031 REQUIREMENTS
1. AN ACTUAL "EXCHANGE" MUST TAKE PLACE. You must either directly swap properties with your buyer's property; or the buyer in exchange for your deed will acquire the replacement property for you; or you must hire an expert to act as the "Trustee", "Facilitator", or "Qualified Intermediary".
2. THE TRANSFER MUST INVOLVE REAL PROPERTY FOR REAL PROPERTY.
3. THE PROPERTIES YOU SELL AND ACQUIRE MUST BE HELD FOR PRODUCTIVE USE IN A TRADE, BUSINESS, OR AS AN INVESTMENT.
4. THE 45 DAY AND 180 DAY MAXIMUM TIMING RETUIREMENTS FOR IDENTIFYING AND ACQUIRING REPLACEMENT PROPERTIES MUST BE MET.
5. SECTION 1031 IS MANDATORY. If you have accomplished the above 4 requirements, the IRS and the courts will call it an exchange even if you did not intend for it to be so.
IN CONCLUSION
Again, I would like to emphasize -- the best advise I can give you is to USE EXPERTS!! It is too easy to make a mistake and lose your tax deferral. Improperly documented exchanges, even if you state your intentions in writing, have led to numerous DISALLOWED EXCHANGES by the IRS. Missing the 45 day or 180 day rule deadlines will cause the entire exchange to be DISALLOWED!
The penalties are severe! The IRS can assess the back taxes owed with a 25% PENALTY, and all at 20% INTEREST. A $ 10,000 tax owed could add up to a total of $ 17,500 due in two years when you get audited.
The IRS strongly believes in substance over intention. In other words, you must prove your intentions of doing an exchange, in writing, each step of the way. The IRS requires that you use either a "Qualified Intermediary" or "Qualified Escrow Accounts" (where the buyer of your property will buy the replacement property for you), or a "Qualified Trust" (where you hire a Trustee to hold the buyers money and acquire the replacement property for you).