1031 Exchange Terminology
There may be many unfamiliar terms used when discussing 1031 exchanges and replacement properties, so we have compiled a list of some of the most common. We want to make sure that this process is as simple as possible, so please let us know if you have any questions or need further explanation.
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The term “accommodator” refers to a qualified intermediary.
Direct access to exchange funds or other property is possible. Your exchange will be disqualified if you receive exchange funds during the exchange period.
You use this amount to calculate your capital gain or loss from a sale or disposition of property. It is necessary to start with the original purchase cost when determining the adjusted cost basis for your property. Once you have added out-of-pocket expenses such as brokerage commissions, escrow fees, title insurance premiums, and other closing costs directly related to the acquisition, subtract depreciation you have taken, casualty losses you have suffered, and any demolitions you have carried out. Then subtract the cost of capital improvements and the principal payments of special assessments (sewer and streets).
Capital gain and depreciation recapture taxes are deferred 100% in a balanced exchange. As a result of a balanced exchange! ) Reinvest all the net equity from the relinquished property in the replacement property to acquire a replacement property that is equal to or greater in value: 2) acquire a replacement property with a value equal to or greater than the relinquished property,, and 3) assume debt on the replacement property equal to or greater than the debt on the replacement property or contribute cash to make up the deficit.
The qualified intermediary and/or exchange accommodation titleholder (EAT) acquires and holds title to the replacement property through a tax-deferred exchange. An improvement exchange is also called an exchange of improvements.
As a result of the exchange, the taxpayer receives something that is not like-kind to the relinquished property. There are two types of boots: cash boot and mortgage boot. Net boot received determines the amount of realized gain.
- Mortgage boot received offsets cash boot paid (debt relief)
- The mortgage boot paid (debt assumed) offsets the mortgage boot received
- Cash boot received does not offset mortgage boot paid
It is necessary to limit the exchangor’s right to receive money or other property.
According to these limitations, the exchangor may not, in accordance with the Until the end of the identification period, the exchangor is not entitled to receive money or non-like-kind property. (if the exchangor has not identified any replacement property within 45 days); In the event that the exchangor receives all of the identified replacement property (or if identification failed because of an unfulfilled material and substantial written contingency, such as zoning approval), or when the 180-day reinvestment period for a calendar year exchanger expires.
In the case of an exchange after July 4, tax recognition of the boot received could be deferred for one year since the receipt of the non-like-kind property occurs in the following tax year.
During the 180 days following this midyear date, if the property was properly identified but never acquired for bona fide reasons, the deferral also applies.
IRS Form 1099-S box 2 should be omitted regardless of whether or not the exchangor receives boot or money from the QI.
The capital gain is calculated by reducing the adjusted basis of the relinquished property by the total selling price of the relinquished property. Original cost plus capital improvements, less depreciation or cost recovery deductions, is the adjusted basis. The Internal Revenue Service may apply depreciation recapture rules to capital gains.
A property’s adjusted cost basis is the difference between its selling price and its cost basis.
An asset’s adjusted cost basis minus its selling price.
Investment tax imposed by the federal and state governments on investments held for more than one year. There are many types of investments, including real estate, stocks, bonds, collectibles, and tangible depreciable personal property.
Improving your land or building (also known as capital improvements) means upgrading it permanently rather than maintaining or repairing it. The cost of improvements is added to the basis of the property instead of being deducted in the year paid. Whenever you make improvements to a building that is depreciating, you must depreciate the improvements over the same time frame.
It is necessary to include language in purchase and sale agreements for both relinquished and replacement property that indicates and discloses that the exchange is intended to be tax-deferred and like-kind, and that all parties must cooperate to complete it.
Co-Tenancy is a concept in property law, particularly derived from the common law of real property, which describes the various ways in which more than one person can own property at a given time. The term co-owner, co-tenant, or joint tenant is used for more than one person living on the same property.
Depending on the type of ownership, the parties may sell their interest in the property, will the property to their devisees, or dissolve their joint ownership. As each of these provides different rights and responsibilities to the co-owners of the property, each requires a different set of conditions in order to exist. Co-tenancies generally allow the following:
- The property is accessible to each owner without restriction.
- Profits made by property owners are entitled to an accounting. The owner of a property is entitled to a pro-rata share of the income (such as rent) or tax credit (such as depreciation).
A reduction in tax that can be applied to gross income, to gross estates, or to gifts.
An exchange transaction structured as a tax-deferred, like-kind exchange of real estate or personal property (relinquished property) in order to defer federal, as well as in most cases state, capital gain and depreciation recapture taxes is a tax-deferred, like-kind exchange transaction. The sale or disposition of real estate or personal property (relinquished property) is structured as a tax-deferred, like-kind exchange transaction.
Like-kind exchange where the relinquished property and replacement property are transferred later than the exchangor’s relinquished property closes.
Invested in or used for trade or business property that has a useful life of more than one year. Instead of deducting cost when the asset is placed in service, you spread the cost over its estimated useful life.
A property’s economic life is marked by periodic wear and tear. Investors and business owners are required to take a tax deduction for depreciating properties. Depreciable property is amortized, or spread, over a specified period of time, usually its estimated depreciable life. As a result, if you wear away or expense property or assets over time, such as aircraft, vehicles, livestock and buildings, you can deduct it on your income tax return. An asset rated as depreciable is one that has a definite useful life of more than one year and is used in a business or trade. Land that is not depreciable is included in non-depreciable property. If an asset has an estimated useful life of more than one year, you spread the cost over its estimated useful life rather than deducting the entire cost in the first year. Different types of assets have different depreciation periods specified by law.
Depreciation expense that has previously been deducted from taxpayers’ income tax returns is recovered by the disposition of property.
In accordance with Treasury Revenue Ruling 90-34, either the relinquished property or the replacement property may be deeded directly from seller to buyer without going through a Qualified Intermediary.
An exchange of like-kind property or an involuntary conversion of property that results in a gain or loss.
A property’s market value less any real estate owned by the owner, if there are no claims or liens.
As a tax-deferred, like-kind exchange transaction, the sale or disposition of real estate or personal property (relinquished property) and the purchase of like-kind real estate or personal property (replacement property) are structured to defer taxes on capital gains and depreciation recapture under Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations. Please refer to 1031 Exchange.
According to Revenue Procedure 2000-37, a qualified intermediary holds the title to either the replacement or relinquished property to facilitate a reverse exchange or construction exchange.
As part of the tax-deferred, like-kind exchange, the qualified intermediary and the exchangor must sign a written agreement outlining the exchangor’s intent to exchange relinquished property for replacement property and describing the parties’ duties and responsibilities.
A tax deferred exchange is sought by the owner of the investment property. A taxpayer who completes a like-kind exchange tax-deferred.
An exchangor may be an individual, partnership, LLC, corporation, institution or business.
To hold exchange funds, the qualified intermediary establishes an account.
It is not possible to exchange like-kind property for personal use (homes, boats, and cars); cash; stock in trade or any other property held primarily for sale (such as inventories, raw materials, or real estate owned by dealers); bonds, notes, stocks, securities or evidence of indebtedness (such as receivables); partnership interests; certificates of trust or beneficial interests.
When the exchangor must acquire the replacement property(ies) in a tax-deferred, like-kind exchange. Exchange periods are 180 calendar days after the transfer of the exchangor’s first relinquished property, or until the due date (including extensions) of the exchangor’s income tax return for the year in which the like-kind exchange transaction occurred, whichever is earlier. Holidays and weekends are not included in the exchange period.
Partially owned property with an undivided fractional interest. Also see Tenant-In-Common Interest.
After the relinquished property closes escrow, the time period begins. In order to continue with the section 1031 exchange, the exchanger must identify the replacement property within 45 days. Exchangors’ relinquished property must be transferred within 45 calendar days after transfer and weekends and holidays are not counted.
This form is is used to remove previously identified replacement properties within 45 days of their identification. A change of identified properties may be made at any time and as many times as desired during the 45-day identification period, but cannot be made afterward.
A 1031 exchange must follow certain guidelines. A choice must be made by the exchanger:
Three Property Rule – Exchangors may identify up to three properties without considering their value.
200% Percent Rule – Exchangors may identify more than three properties, but not more than 200% of the relinquished property’s value.
95% Percent Rule – If the exchanger acquires 95% of the fair market value of the identified properties, it may identify any number of properties.
Build-To-Suit exchanges are similar to Construction Exchanges.
Improving your land or building (also known as capital improvements) means upgrading it permanently rather than maintaining or repairing it. You add the cost of improvements to the basis of the property instead of deducting them in the year of payment. You must depreciate improvements over the same useful life as the building if the property you improved is a building that is being depreciated.
During the 45-day identification period, an Identification Statement is used to identify potential replacement properties.
Unrelated party participating in a tax-deferred, like-kind exchange to facilitate the disposition of the exchangor’s relinquished property and the acquisition of the exchangor’s replacement property. As defined in Section 1031 of the Internal Revenue Code, the Intermediary has no economic interest except for any compensation (exchange fee) it may receive in connection with facilitating the exchange. Technically, the Intermediary is called a Qualified Intermediary (QI), but he or she may also be called an accommodator or facilitator.
It is necessary to acquire replacement property that is “like-kind” to the property being relinquished in an exchange. In the United States, all qualifying real estate is like-kind. A relinquished item must be of like kind or class to the item acquired. A property located outside of the United States is not equivalent to a property located within the country.
There must be a similarity in nature or characteristics between the properties involved in a tax-deferred exchange. Basically, like-kind properties are any real estate that isn’t your primary residence or a second home. Exchanging property with another property. Not the grade or quality of the property, but its nature or character.
Exchangors own any property other than real estate that is personal property. There are more restrictions on personal property exchanges under the “Like Kind” Rules. An airplane with four engines can be exchanged for another with four engines, but not for one with two engines. Even though both are considered works of art, you cannot exchange a painting for a sculpture. Personal Property Exchange can be found here.
In mortgage boot, the taxpayer assumes or gives up liabilities. Taxpayers pay mortgage boot when they assume or place debt on replacement properties. Mortgage boot is received when the taxpayer is relieved of debt on the replacement property. The taxpayer is relieved of debt if they don’t acquire debt equal to or greater than the debt that was paid off. In a debt relief transaction, the debt relief portion is taxable, unless it is offset when netting against other boot
In mortgage boot or mortgage relief, you assume debt for your replacement property that is less than your relinquished property’s debt. If cash boot is added or given up in exchange, mortgage boot received triggers the recognition of gain and is taxable.
Section 1031 exchanges involving the sale and/or acquisition of multiple properties.
Exchanges involving boots and partial success. An exchanger receives cash and/or excludes property and/or non-like-kind property as well as debt relief (mortgage reduction) on the replacement property. Tax liabilities would be incurred on the non-qualifying portion of a partial exchange, while capital gains would be deferred on the qualifying portion.
The exchangor’s non-real estate related property.
Personal property (relinquished property) is exchanged for like-kind or like-class replacement property that is tax-deferred. Please refer to Like-Kind Personal Property.
During this process, the relinquished property is sold and all necessary paperwork is completed. As part of the tax-deferred exchange process, this process is also called the “down-leg.”
The process of buying a replacement property and completing all the associated paperwork. The tax deferred exchange process is also referred to as the “up-leg.”
Under IRS Section 121, individuals and couples filing jointly are exempt from capital gains tax on the sale of their principal residences. During the last 60 months, the taxpayer(s) must have lived in the property as their principal residence. As a result of Code Section 1031, taxpayers can defer taxes on the portion of their property used for business or investment while excluding capital gains on the portion that is used as their primary residence. This applies to ranches, retail stores, duplexes and triplexes.
Both the relinquished and replacement properties must be used in a trade or business or as investments. Acquiring property with the intention of reselling it immediately will not qualify. It will not be possible to claim the taxpayer’s personal residence as a deduction.
An escrow account, where the escrow agent (QI) is not the exchangor or a disqualified person,, and which limits the exchangor’s rights to receive, pledge, borrow, or otherwise obtain the tax-deferred, like-kind exchange cash balance and/or other assets from the sale of the relinquished property in compliance with Treasury Regulations. Also, Qualified Escrow Accounts ensure the exchange funds and/or assets of the exchangor are held in fiduciary status, protecting them from claims from the Qualified Intermediary’s creditors.
Exchange Accommodator Titleholder (EAT) holds parked property pursuant to Revenue Procedure 2000-37 under a contractual arrangement between the exchanger and the EAT.
In accordance with Section 1031 of the Internal Revenue Code, a Qualified Intermediary facilitates tax-deferred exchanges. Taxpayer or disqualified person cannot be the QI.
- The QI acquires the relinquished property and transfers it to the buyer under a written agreement with the taxpayer.
- Taxpayers cannot receive actual or constructive receipt of the sales proceeds unless the QI holds them.
- In order to complete the exchange within the appropriate time frame, the QI acquires the replacement property and transfers it to the taxpayer.
The qualified use test requires the exchangor to intend to use the property in their trade or business, to hold the property for investment, or to hold the property for income production. Real property includes land and buildings (improvements), which includes but are not limited to homes, apartment buildings, shopping centers, commercial buildings, factories, condominiums, leases of more than 30 years, quarries and oil fields. Exchanges are possible between all types of real property. Real property is generally defined by state law.
Section 1031 does not apply to certain types of property. The treatment of the property as tax-deferred can generally be applied if it is not specifically excluded.
- Assets held primarily for resale
- stocks, bonds or notes
- other securities or evidence of indebtedness
- interests in a partnership
- certificates of trusts or beneficial interest
As a result of the exchange, the taxpayer’s economic position has improved. Realized gains are taxed in a sale.
Taxable gains are recognized gains. Realized gain is greater than net boot received, but less than realized gain.
Real estate exchange. Agribusiness land, residential, commercial, and even long-term leases are all like-kind real estate.
Like-kind exchange transactions involve the exchanger selling or disposing of property. When a taxpayer makes an exchange, the original property is sold.
As part of the tax-deferred, like-kind exchange transaction, the exchanger will acquire or receive like-kind property. During an exchange, the taxpayer acquires new property.
Relinquished property is sold before the Replacement Property is purchased. Like-kind exchanges that occur tax-deferred; replacement property is acquired first, relinquished property is disposed of later.
As part of the Reverse Exchange, the EAT can improve the replacement property.
As long as good faith is demonstrated to comply with laws and regulations, liability can be reduced or eliminated. The Treasury Regulations provide a safe harbor for the use of a QI. This safe harbor prevents the IRS from considering the taxpayer as receiving the funds if the taxpayer meets the requirements.
A note secured by a deed of trust or mortgage given to the seller by the buyer of a property. If seller carry-back financing is not sold at a discount on the secondary market or assigned to the seller as a down payment on the replacement property, it is treated as boot under Section 1031 Exchanges.
Buying a replacement property and disposing of the relinquished property at the same time is a tax-deferred, like-kind exchange transaction. Similarly, a concurrent exchange is referred to as simultaneous exchange.
The starker exchange is an exchange where the proceeds from the sale of real estate stay, in theory, on the Intermediary’s table until the Seller finds suitable property for the exchange. It is like the exchange is held “in suspension” by the Intermediary. No money or deeds actually change hands between the Buyer and Seller in the initial stage of the starker exchange.
When you identify a replacement property within 45 days and fail to complete the starker exchange within 180 days, you may have theoretically sold your farm, but you won’t be taxed on your “theoretical” profits.
The depreciation method spreads the cost or other basis of property over its estimated useful life evenly.
Physically existing property other than real estate. An example of tangible personal property is an aircraft, business equipment, or vehicle. A trademark, patent, or franchise represents only value, and thus is an intangible asset.
Client, investor, exchangor. The person or entity this is completing the tax-deferred like -kind exchange transaction, commonly referred to as exchangor.
Title to property is held by the entity that owns/holds it. It is generally required that the titleholder of the relinquished property and the titleholder of the replacement property be the same in an IRC Section 1031 Exchange. A taxpayer’s estate may complete the exchange if he or she dies before the replacement property is acquired. Disregarded entities (such as single-member LLCs and Revocable Living Trusts) and disregarded entities (such as revocable living trusts) usually qualify for exchanges.
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