1031 Exchanges
revised 2008 by Paula Frey and Stacy Conner
Q #1 What is meant by the term "Like Kind Property"?
The Q of "What is like kind property?" often confuses investors. Section 1031 of the Internal Revenue Code allows real estate investors or business owners to trade property held for productive use in trade or business or for investment for similar property without paying capital gains tax. Similar classes of property are called "like kind." The class of real estate is very broad and includes vacant land, office buildings, houses, warehouses, shopping centers and any other form of real estate held for investment purposes. Almost any form of real estate that the typical investor might acquire in his lifetime can be traded for any other.
Q # 2 What time periods must you work within?
The traditional like kind exchange is referred to as a "simultaneous exchange." A and B both own investment property, and both want to swap. On the day of settlement, A conveys a deed to B, and B conveys a deed to A. This is the traditional, classical 1031 exchange. Congress was concerned about the expansion of this like kind exchange concept. Accordingly, in 1984 it put two major limitations on the Starker (non simultaneous) exchange.
First, the property to be received by the taxpayer must be identified as such before the 45th day after the date on which the relinquished property is transferred.
Second, the new property must be acquired within 180 days after the earlier of:
• the date on which the taxpayer transfers the relinquished property or
• the due date (with extensions) of the taxpayer's federal income tax return for the year in which the taxpayer transferred the relinquished property.
Q #3 Is it possible to combine an IRC 1031 Exchange with the sale of a primary residence?
It is possible to work with both an IRC 1031 exchange and the sale of a principal residence on the same parcel of property by allocating total value between the personal residence and the exchange portion. Examples of this situation include:
• A working farm containing the farmer's residence...the working land would fall under section 1031 rules while the farmer’s home would fall under the personal residence.
• A duplex or similar plex with one unit owner occupied personal residence, the balance tenant occupied (1031).
• A residence (partial 1031) containing a home office (1031).
Q #4 Is it possible to purchase the replacement property prior to disposing of the relinquished property?
Through the use of the Reverse Exchange, a property may be acquired today to replace a property yet to be relinquished. This technique, though aggressive, is currently rapidly gaining in popularity. There are three primary versions of this transaction in use today.
Once the Facilitator acquires the desired replacement property, the Facilitator and Exchangor swap properties. The Exchanger now owns the property he desires and has simultaneously traded his property away. The Facilitator keeps the Exchanger's former property until a buyer is found. The Facilitator then sells the Exchanger's former property to complete the transaction.
After the Facilitator acquires the desired property, the Facilitator retains ownership until the Exchanger has found a buyer for his property. Upon the closing of the sale of the Relinquished Property, the Facilitator transfers ownership of the Replacement Property to the Exchangor.
When a Reverse Exchange is contemplated, the investor must determine how the acquisition will be financed. The down payment must be available to the Facilitator to purchase the property. This is normally borrowed by the Facilitator and repaid when the Exchanger's property is later sold by the Facilitator. The Exchanger must also decide which properties he wishes to keep until the final sale.
Q #5 Does all construction need to be completed within 180 days in an improvement exchange?
To answer this question properly, we must first address the identification of an Improvement Exchange property. The identification will qualify if the normal identification rules are followed and if as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made.
The Replacement Property may qualify as like kind property even if it is only partially constructed (e.g., 20 percent complete) as of the date the Replacement Property is conveyed to the Exchanger, provided the Replacement Property is real estate. The consideration for Replacement Property would be the value of the completed improvements and the land at the time the property is transferred to the exchanger.
Example: Identified improvements valued at $100,000 (100% complete)
Identified land valued at $50,000.
At the time title is transferred to the exchanger, construction is 50% complete. The exchange value of the Replacement Property would be $100,000 (land $50,000 and improvement $50,000)
Q #6 Does the 1031 qualified intermediary need to be located in the exchanger’s general area?
Since Section 1031 is part of the federal tax code and the exchanger may sell or acquire properties located in any part of the United States, it is important to note that a qualified intermediary may handle transactions in any state. However, certain states have licensing requirements with regard to properties sold within that state and the qualified intermediary must adhere to those licensing requirements.