Frequently Asked Questions about 1031 Exchanges 

These “Frequently Asked Questions” are provided to answer general inquiries regarding Section 1031 Exchanges.  Every exchange is unique and different and the application of the basic principles depends on the specific facts of each transaction.  The following information is designed to provide general information and it is suggested that a Qualified Intermediary, attorney, or tax advisor be consulted to determine how an exchange may best be structured to accomplish your investment objectives.
 

• What is a tax-deferred exchange?

Section 1031 of the Internal Revenue Code 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.  In a typical (not an exchange) transaction, the property owner is taxed on any gain realized from the sale.  However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.  In an Exchange, a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.

An exchange under Section 1031 is tax-deferred, not tax-free.  When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
 

• What does the term “Starker” refer to?

Starker refers to the landmark 1979 Federal Case titled Starker v. U.S. 602 F2d 1341 (9^th Cir 1979).  The Court substantiated the validity of the delayed exchange process in this case.
 

• What are “Safe Harbors”?

The term “Safe Harbors” refers to rules established by Treasury Regulations for tax deferred exchanges.  If followed, the IRS will allow the exchange to qualify.
 

• What is a "Qualified Intermediary" (QI) and what services does a QI perform?

A Qualified Intermediary (QI) is an independent party who facilitates tax deferred exchanges according to Section 1031 of the Internal Revenue Code.  A QI cannot be the taxpayer or a disqualified person.  Services: 

o   Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.

o   The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.

o   The QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits. 
 

• Why is a Qualified Intermediary needed?

The use of a QI is a safe harbor rule established by the IRS.  The exchange would end the moment the taxpayer had actual or constructive receipt of the proceeds from the sale of the relinquished property.
 

• What is “Relinquished” Property and “Replacement” Property?

Relinquished property or Property Sold is the property given up by the Exchanger in the 1031 exchange transaction.  The Replacement property or Property Bought is the property the Exchanger acquires in a 1031 exchange.
 

• Can the replacement property eventually be converted to the taxpayer's primary residence?

Yes, however, the holding requirements must be met prior to changing the primary use of the property.  The IRS has published regulations that the taxpayer must own the property for five (5) years and occupy is as a primary residence for two (2) years.  The two years can be part of the five years.
 

• Is it too late to begin a tax-deferred exchange if the taxpayer has
  already signed a contract to sell the relinquished property?

No.  A tax deferred exchange can still be set up as long as the taxpayer has not transferred title, or the benefits and burdens of the relinquished property.  Once the closing has occurred, it is too late to begin an exchange even if the taxpayer has not cashed the proceeds check.
 

• What are the 45 and 180 day time restrictions on completing an
  Exchange?

The taxpayer has 45 days after the date that the relinquished property is transferred to identify potential replacement properties and 180 days (or the due date for your tax return for the year in which the relinquished property was transferred – whichever is earlier) to complete the acquisition of those properties.  It should be noted that the 45 day ID period and the 180 day exchange period are calendar days.  If either one falls on a weekend or holiday, the deadlines still apply.  There are no extensions for Saturdays, Sundays or legal holidays. For a calendar year taxpayer, the exchange period may be cut short for an exchange that begins after October 17^th.  However, the taxpayer can get the full 180 days, by obtaining an extension of the due date for filing the tax return.
 

• What if the taxpayer cannot identify replacement property within 45 days, or close on a replacement property before the end of the exchange period (180 days)?

There are no extensions available.  The exchange will fail and the taxpayer will have to pay any taxes due from the sale of the relinquished property.
 

• What are the rules for identifying properties?

The identification letter must be in writing, signed by the taxpayer and hand delivered, mailed, faxed or otherwise sent to the Qualified Intermediary.

There are 3 rules governing the identification of replacement properties and the taxpayer must meet the requirements of at least one of these rules:

• What is “Like Kind”?

Real or personal property of the same nature or quality is like kind. In general terms, real property is like kind to all other real property (except foreign real property) as long as it is held for investment or the productive use in a trade or business.  Personal Property must be either the same General Asset Class or Product Class.
 

• What is Boot?

Boot is any type of property received in an exchange that is not like kind, such as cash, mortgage notes, a boat, or stock.  The Exchanger pays taxes on the boot to the extent of recognized capital gain.  In an exchange, any funds not used to purchase the replacement property will be called boot.

In order for an Exchange to be completely tax-free, the taxpayer must not receive any boot.  If boot is received, it is taxable.  This is acceptable if the seller desires some cash and is willing to pay some taxes.  It should be noted that the term “boot” is not used in the Internal Revenue Code or the Regulations, but it is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange.
 

• Can improvements to the replacement property be made with proceeds from the relinquished property?

Yes.  The Exchange would then be considered a Construction or Improvement Exchange and it would be necessary for the QI to take title to the replacement property, make the improvements, and then convey title to the taxpayer before the end of the exchange period.  The taxpayer is not permitted to build on property they already own.
 

• Can the taxpayer take out the basis and reinvest only the gains?

No.  Both the basis and gain must be reinvested to defer taxes.  It is not allowed by the IRS for the taxpayer to allocate a portion of the money as basis and a portion as gain.  Any money received by the taxpayer will be considered boot and taxed at a capital gain rate.
 

• What is the net value of the relinquished property?

The net value is the sales price less any closing costs.  The taxpayer is responsible for reinvesting both the cash and the loan amount when purchasing the replacement property.
 

• What is “basis”?

Basis is the starting point for determining gain or loss in any transaction.  In general, it is the cost of the property.
 

• What is “adjusted basis”?

Stated simply, the adjusted basis is equal to the purchase price, plus capital improvements, less depreciation.  Transaction involving exchanges, gifts, probates and trust distributions may impact the property’s adjusted basis.  The Exchanger’s tax and legal advisor is the party to look to for determining adjusted basis.
 

• What does the term “disqualified party” refer to?

Treasury Regulations provide that certain persons/entities are disqualified from acting as an Intermediary.  Disqualified persons include anyone who can be considered your agent, anyone who is a related person as defined in the Code, or anyone who bears  relationship as your agent as described in the Code.  Your agents include anyone who has acted as your employee, attorney, accountant, investment banker, real estate agent or broker within the previous two years.
 

• Can an exchange be done with a related party?

Yes, but it is subject to certain restrictions.  If the exchange is with a related person, the taxpayer is entitled to non-recognition of gain only if the replacement property is held by the taxpayer for at least 2 years and the relinquished property is held by the related person for at least 2 years after the date of the last transfer in the exchange transaction.  Related persons include members of the taxpayer’s family and descendents, corporations, tax-exempt organizations and partnerships that are controlled or owned by the taxpayer.  The grantor, fiduciary and beneficiary of a trust are also considered related parties.
 

• What are exchange expenses?

Certain expenses incurred in selling the relinquished property, which include but are not limited to the real estate commission, exchange fees, legal fees and transfer taxes, may be paid with exchange proceeds thereby reducing the amount that must be reinvested in the replacement property.

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