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1031 Exchange constitutes the exchange of like-kind properties. These like-kind properties must have been used in trade or for investment. However, this trade or investment must not be in the form of shares, notes, stocks, bonds, certificates, and similar forms of financial instruments. In addition to the aforesaid forms of trade, properties of personal residence and those in foreign land cannot be traded using 1031 exchange too. Further, properties which are “stock in trade,” for instance, flats built and put on sale by a developer, are also barred from exchange during 1031 exchange.
Only investors are permitted to take part in 1031 exchanges and not dealers. The definition of dealers, though is not clear, it is explained using some examples. Multiple and recurring exchanges and trades by an investor within a very short period of time makes him a dealer and the properties as stock in trade, thus excluding them from the permissible list of exchanges in 1031 exchange.
Moving past the who can exchange part, comes what can be exchanged. 1031 exchange allows trade of both “real property” and “personal property,” as long as the property falls under the like-kind property category. Like-kind property as the name suggests, refers to the properties of similar kind with only similarity in the nature of investment being the prerequisite. For example, a single bedroom flat can be exchanged for a duplex, land for a building, and an office for an apartment(s).
1031 Exchange excludes properties involved in trade or used in investments in the form of bonds, stocks, notes, securities and interests in partnerships. Properties on foreign lands and properties used for personal residence are also banned from participating in the 1031 exchange. However, a portion of the primary residence used for investment can be used in 1031 Exchange.
As dealers are not allowed to participate in 1031 exchange, therefore properties that dealers purchase and put up for sale are also excluded.
Before getting started in a 1031 exchange it is crucial that you do your own research both about the properties you want to exchange and the exchange facilitator you will be contacting.
It is always important to ask the right questions and for that you need to do your homework. So once you have a background, contact an exchange facilitator. Be prepared with all the information you can get your hands on about the relinquished property and if you have any exchange properties on the list. But at the same time, also understand and discuss what services they can offer, for example discuss the properties they have in their database which can be useful for you.
Your exchange facilitator is going to play a very important role in the exchange, thus it is necessary that you not just listen to them but also ask questions and clear all your doubts.
A facilitation company facilitates and helps in preparing for the exchange. The names of the facilitation company or commonly called as the facilitator can be obtained from varied sources, namely, a quick google search, attorneys, CPAs, and real estate agents. However, keep in mind that the aforementioned are mere agents or sources of finding a facilitator and not a facilitator themselves.
While choosing a facilitator for your exchange, ensure to ask the right questions. Pricing i.e. the exchange fee the facilitator will charge, a detailed document of the assistance they will be offering, and the entire procedure of the exchange, should all be discussed before finalizing a facilitator. The present industry rate for exchange facilitation varies in the range $400 to $750.
In an exchange time plays a crucial role. There are two important time periods the investor needs to be critical of. During an exchange, after the investor has closed the deal on the relinquished property, he/she has 45 days to identify and consequently nominate a replacement property or multiple properties.
Post identifying and nominating the replacement properties, the investor has an additional of 135 days (i.e. a total of 180 days from the day of closing on the relinquished property) to acquire one or more than one of the nominated properties. In case an investor is looking to nominate more than 3 properties, it is advisable to have a facilitator on board to simplify and fasten the process.
The investor also has to provide an unambiguous description for the identified properties within the first 45 days.
In addition to the time restraints, there are some other factors that might appear as challenges in the process of exchange. Below are some guidelines that come handy during the process.
Exchange funds can be used for paying closing costs as per the Internal Revenue Service. However, it is restricted to only Exchange Expenses i.e. exchange funds can be deployed only for exchange expenses.
Exchange expenses, also known as Normal Transactional Costs, are the costs/expenses only associated with the exchange. Further, Exchange Expenses are non-taxable while Non Exchange Expenses are taxable.
Exchange funds can be used for non-exchange expenses only at closing. Such transactions will be taxed unlike transactions made for exchange expenses.
Exchange Expenses include sales commission, legal fees, property taxes, document fees, etc. Non Exchange Expenses on the other hand include utilities, mortgage insurance, security deposits, etc. The table below details the different kinds of costs and the category they come under.
| Exchange Expenses | Non Exchange Expenses |
| Sales Commission | Rent Proration |
| Legal/ Finders/ Escrow/ Testing/ Recording / Exchange/ Document/ Statement/ Messenger/ Notary Fee | Mortgage/ Property Liability/ Lender’s Title/ Assumption Insurance |
| Property and Transfer Taxes | Security deposits/dues |
You can use your exchange funds for any non-exchange expenses as well. However, you will have to pay taxes on such transactions.
Yes, a vacation home does qualify for the list of properties in 1031 exchanges. A vacation home is not considered a property used for personal residency and thus is allowed for exchanges, as per the Revenue Procedure 2008-16, which came into effect from March 10, 2008. As per the revenue procedure, a vacation home property can be considered both a relinquished and a replacement property, with minute differences in the two. Below are the essential qualifications.
While the primary information required to structure an exchange includes details about the Exchangor and the Escrow Officer. These include the name, address, contact details, and the Escrow officer’s escrow number.
However, for a deep analysis and review of the exchange and thus a smooth structuring of the exchange, information about the property being relinquished and replaced, such as its date of acquisition, cost, ownership details, past and pending deals, and its value, equity and mortgage are also required.
Yes, one can indulge in exchange of multiple properties in and out. However, the investor must go up in the value, equity, and mortgage of the exchanged property(ies) in comparison to the relinquished property(ies). Additionally, one must keep in mind the time restrictions associated with the exchange procedure.
Though there is no defined time period for holding a property before converting the nature of use of the property, but it is the intent that matters. In 1031 exchange one must have the intention of investment, with long-term moving in being one of the options. Having said that, it is always advisable to wait for a year before changing the nature of the use of the property unless in life changing events.
Yes, if you have found the potential replacement property and want to make an offer, you can, even if your relinquished property is still unsold. This exchange works as long as the replacement property deal is closed after the relinquished property is sold (even if the two deals are separated by a gap of a few minutes).
However, in special circumstances, if you want to make an offer and buy the replacement property on an urgent basis even before the closing of your relinquished property, this can be achieved using a reverse exchange. Though costilier, the method is often used by exchangors.
1031 exchange allows exchangors to invest in cross-border properties. However, the varying tax policy and system for each state must be reviewed and taken into consideration before making a deal.
For 1031 exchange, the IRS has always focused on the intent of buying and selling a property rather than the time duration. The IRS has not specified any minimum time period for holding a property before doing an exchange. Having said that, the IRS also doesn’t entertain frequent and recurring sale and resale of properties. This again brings us to the intent of buying the property, which is the dealbreaker in 1031 exchanges. The government and industry has however always advised that a one-year hold period for an exchange should be maintained.
The process of exchange is similar yet unique for each client and each situation. Transactions can range from being simple and quick to extremely complex. While simpler transactions start at an early price of $400 to $1,000, complex transactions can cost a minimum of $3,500. Price varies with the complexity of the transaction and the services required and offered.
With safety and trust being our utmost priority, we have a history of proven transactions on which our company’s reputation is built. The exchange funds once received, are placed in a money market savings account and not moved before closing, that too on the authorization by the Exchangor.
Additionally, our company is insured by a fidelity bond for up to $5,000,000 for each occurrence and an Errors and Omissions policy for $1,000,000 per claim.
As the exchange process comes under Normal Transactional Costs or Exchange Expenses it is non-taxable. Thus, to be completely tax deferred, the replacement property bought must be of the same or greater value than the relinquished property. If the value of replacement property is lesser than relinquished property, the difference would be taxed as it comes under the non-expense category and is taxable. This difference though can be used for any purposes as wished by the investor. Therefore, it is always advised to have your replacement property value equal to or more than the relinquished property.
Any initial investment made on the property cannot be reimbursed. Funds from exchange money can be taken out for non-exchange expenses, however, they will be taxed.
Yes, it is possible as long as your business officially pays the rent for the space as per the market standards and is not favored in comparison to other tenants.
Yes, an investment property can be converted to a primary residence by holding it for a minimum of 5 years. Post completion of the holding period, individuals can sell the residential property and receive tax exemption under The Universal Exclusion (Section 121). However, for this, the individual must have lived in the property for at least 2 years of the 5 years of holding period. A single individual can get a tax exemption on $250,000 while a married couple can get an exemption of $500,000.
What concerns the IRS is the intent of your investment. It does not appreciate frequent selling and reselling of the property. What matters in this situation is how and if you are able to prove your intent of investment on the property. For instance, if your intent was of resale while buying the property a year back, then it doesn’t qualify for the exchange. In addition to your intent, the time for which you have held the property and the past dealings on it also play an important role.
1031 exchange does not permit exchange with property on foreign land. The law permits exchange only for U.S. to U.S. and property on foreign land to property on foreign land. However, States to US territory exchange has been permitted.
Yes, it is possible to use exchange funds for improving a property that you already own. To know the details of the process, you can contact us.
When talking about business exchanges, it is important to understand that two businesses as whole cannot be exchanged. It is the components of the business that are exchanged. The real estate part of a hotel i.e. the land or the building can be exchanged with the land or the building of a restaurant. There need not be any similarity in form of businesses. The only prerequisite here is the similarity in the nature of investment. Thus, two businesses cannot be traded as such but respective portions of the two can be.
Refinancing a property for exchange presents as a question to your intent of investing in that property. Thus, the short answer to this question is No. However, if you still wish to do it, try to maintain a gap of at least 6 months to a year between the refinance and exchange.
Buying an auctioned property is possible, however, the process is complicated. According to IRS rules it is mandatory to update the list of potential replacement properties along with an unambiguous property description within 45 days of closing on relinquished property. Therefore, for a property on the auction list, it is crucial to buy it before the 45 day period. Post buying the auctioned property, the process is similar to that with any other property.
A note can be used in an exchange process, however, the note is a taxable quantity. Thus, for using a note in an exchange deal and defer the taxes at the same time, it is necessary to convert it before closing the deal on replacement property. This can be achieved by selling the note, using cash in acquisition of the replacement property, or buying note from your facilitator.
Though it is possible, if done so, the entire funds received from the sale of relinquished property will be taxed. Thus, it is not advisable to use the proceeds from an exchange for non-exchange expenses such as mortgage. A possible solution could be to do a cash-out refinance and pay off the due mortgage of the property after a considerable period of time.
The basic objective of exchange 1031 requires exchange of property. Though, the popular contractual and royalty rights cannot be exchanged as per IRS, working rights can be. Working interests are considered as real properties owing to the authority it gives the individual to extract resources from land and at the same time invest in the same. Thus, working interests of one kind can be exchanged with working rights of another kind. Additionally, working interests of oil, gas, minerals can also be exchanged for other like-kind properties such as land, apartments, buildings, etc, as long as the nature of investment is similar.
Related party transactions are transactions between people who are directly related to each other or belong to the same group such as siblings, spouse, ancestors, and organizations with a 50% or more ownership with members from the same controlled group. Such transactions, though allowed, are very strictly monitored.
There are certain guidelines for both investors selling and buying properties to and from related parties. For investors selling property to a related party, a minimum holding period of 2 years is to be maintained by both the parties and the related party must not be involved in situations such as 1031 exchange, death, and involuntary conversion (the transaction in such cases stands rejected). On the other hand, for a deal where an investor is buying property from a related party, the latter must have a 1031 exchange or the taxable gain for the buyer party must be equal to or less than the seller’s taxable gain from the deal.
Cancelling an exchange is possible, however, the time frame here is what is tricky. An exchange 1031 deal can be terminated before closing the relinquished property deal, after 45 days – post acquiring all the property you are entitled to as per the rules, and after the completion of the process, i .e. after 180 days.
This process of cancelling the deal also depends on your facilitator. Thus, it is necessary to keep your facilitator in loop and updated.
IRC 1033 and IRC 1031 both find their use for deferment of capital gain on property; however, they have different rules and offer different options to the investors.
IRC 1031, focuses on the type of replacement property and the nature of trade or investment. It mandates the need of a third party intermediary as it does not offer any actual receipts of the sales of relinquished property, rather deposits funds with the exchange facilitator. Under IRC 1031, there’s a 45 day window to identify potential replacement property and 180 days to replace the relinquished property.
IRC 1033 on the other hand, focuses on properties which are involuntarily converted or exchanged i.e. destroyed, stolen, or disposed off. Unlike IRC 1031, IRC 1033 does not mandate the need of a third party or an intermediary and allows payments to be received directly. Further, there are no time restrictions for identifying potential replacement properties. However, IRC 1033 does restrict the value of the properties in deal to be equal to each other.
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