1031 EXCHANGE - RESIDENTIAL

Why Do an IRC 1031 Exchange?

When an owner of investment real property (“Taxpayer”) sells the property, the sale often creates an obligation for payment of capital gains taxes.

Section 1031 of the Internal Revenue Code of 1986 allows a Taxpayer to sell investment real property (“Relinquished Property”), have the proceeds used to purchase new investment real property (“Replacement Property”) and defer the taxes on the sale (the “Deferred Exchange”).

A taxpayer may not simply sell Relinquished Property and use the money to purchase Replacement Property. The IRS and the Treasury Department have very strict requirements which must be satisfied in order for a Taxpayer to qualify for Deferred Exchange treatment (the “Regulations”).

To qualify for a Deferred Exchange, the Taxpayer must enter into a valid exchange agreement (the “Exchange Agreement”) with a third party (the “Qualified Intermediary”). The Qualified Intermediary must hold the funds from the sale of the Relinquished Property and the Taxpayer and the Qualified Intermediary must comply with the requirements of the Regulations.

The Qualified Intermediary will prepare most of the documentation that is required by the Regulations.

The Qualified Intermediary must conduct its business in compliance with the Regulations or your exchange could be jeopardized.

The Regulations on Deferred Exchanges are very complex. An unsophisticated intermediary could unwillingly act in a manner that could cause a Deferred Exchange to be disallowed under audit.

Frequently Asked Questions

How Does the Taxpayer set up an Exchange?

The exchange must be set up before the Taxpayer can close on the sale of the Relinquished Property.

The Qualified Intermediary prepares an Exchange Agreement and an assignment document to assign the Taxpayer’s rights in the sale contract to the Qualified Intermediary.

The Taxpayer and the qualified Intermediary sign the Exchange Agreement and the assignment document. The Buyer of the Relinquished Property also signs the assignment document.

The Qualified Intermediary holds the executed Exchange Agreement. The executed assignment document is delivered to the escrow agent handling the sale of the Relinquished Property.

Once the sale escrow agent gets the assignment, and all other terms of the sale are satisfied, the sale escrow can be closed.

Upon close of the sale escrow the sale escrow agent transfers all of the Seller’s net proceeds to the Qualified Intermediary.

Can the Taxpayer deed the Relinquished Property directly to the Buyer?

Yes, the Regulations allow the Taxpayer to deed the Relinquished Property diretly to the Buyer. This avoids extra fees.

Can the Taxpayer earn interest on the funds while they are held by the Qualified Intermediary?

Yes, the Regulations allow the Taxpayer to earn interest on the funds; however, the interest may not be paid to the Taxpayer until the end of the exchange. The interest which is earned will be taxed as ordinary income.

How long does the Taxpayer have to identify Replacement Property and to complete the exchange?

Replacement Property must be identified on or before midnight of the 45th day following the day on which the sale of the Relinquished Property occurred (the “Identification Period ”).

Provided the identification requirements are satisfied, the exchange must be completed by midnight of the 180th day following the day of close of the Relinquished Property or the due date of the tax return for the year in which the transfer took place, including extensions (the “Exchange Period ”).

The Identification period and Exchange Period must be counted very carefully. They are not extended for holidays or weekends.

 

How many Replacement Properties can the Taxpayer Identify?

1031 regulations allow the Taxpayer to choose a Replacement Property by using any of the following three rules:

Three Property Rule: Three properties without regard to the fair market values of the properties.

200 Percent Rule: Any number of properties as long as their aggregate fair market value does not exceed 200% of the fair market value of all Relinquished Property.

95 Percent Rule: Any number of properties no matter what the aggregate fair market value, provided the Taxpayer receives at least 95% of the aggregate fair market value of the properties identified.

What form does the Taxpayer use to identify Replacement Property?

There is no special “form” however, the identification must be in writing, must be signed by the Taxpayer and must “unambiguously” describe the Replacement Property.

How is the Replacement Property acquired?

The Taxpayer negotiates the purchase of Replacement Property in the normal manner with wording similar to the following inserted in the purchase contract:

Buyers Exchange Provision: It is the intent of Buyer to Acquire this property as Replacement Property in an Internal Revenue Code Section 1031 exchange. To effect such exchange, Buyer reserves the right to assign their position herein to a Qualified Intermediary. Seller agrees to cooperate in Buyers exchange, provided that Seller will be at no additional expense or liability for Buyers exchange and Buyers exchange shall not delay the closing of this escrow.

Before the Replacement Property can close, the Qualified Intermediary prepares an amendment to the Exchange Agreement and an assignment document in which the Taxpayer assigns his rights in the purchase contract to the Qualified Intermediary.

The Qualified Intermediary and the Taxpayer sign the amendment and the assignment. The seller of the Replacement Property also signs the assignment.

When all conditions of the Replacement Property are satisfied, the Qualified Intermediary transfers the required funds to the Replacement property escrow agent.

Federal Tax Rules Clarify Home Sale Capital Gains Exclusions

After years of uncertainty, the IRS has now delivered the answers to questions that have bedeviled home sellers, Realtors and professional tax advisers. The IRS clarified its rules on capital gains exclusions for profits on home sales.

The largest category of people affected are those who sell their homes prior to the standard two-year holding period required for the maximum capital gains exclusions of $250,000 (single filers) and $500,000 (married, joint filers). The standard rules allow sellers to exclude up to those maximum amounts of sale profits provided they have owned and used their property as a principal residence for an aggregate two out of the five years preceding the sale. Any profits beyond the exclusion amounts are taxed at capital gains rates.

For taxpayers who sell after ownership and use of less than two years, Congress created a partial exclusion or shelter back in 1997-1998: You can claim a portion of the maximum exclusion if you sell early because of a change in employment, a change in health, or because of "unforeseen circumstances." For example, a single homeowner who sold his property for a profit after just one year because of a corporate transfer could claim one-half of the full $250,000 standard exclusion = $125,000.

In the absence of formal regulatory guidance from the IRS interpreting employment change, health change and "unforeseen circumstances", many taxpayers have been reluctant to use the partial exclusion. The IRS itself warned taxpayers not to claim "unforeseen circumstances" on their returns until the agency itself spelled out precisely what circumstances qualify.

Now the IRS has done so with interim rules, opening the door to partial exclusion claims for tax year 2002 and any prior year's returns where a refund may be available under the new rules. (For such situations, taxpayers can file for refunds using Form 1040X.)

On "unforeseen circumstances," the IRS lists seven major categories that create a "safe harbor" that automatically makes the claim eligible:

Ђ Death of the taxpayer, a spouse, a co-owner or any member of the taxpayer's household.

Ђ Divorce or legal separation

Ђ A job loss that results in eligibility for unemployment compensation.

Ђ A change in employment that leaves the taxpayer unable to pay the mortgage or basic living expenses.

Ђ Multiple births from the same pregnancy.

Ђ Damage to the residence resulting from a natural or man-made disaster, or an act of war or terrorism.

Ђ Condemnation, seizure or other involuntary conversion of the property.

The regulations also give the IRS commissioner the discretion to determine other circumstances that qualify as unforeseen.

On employment changes that trigger early sales, the IRS rule is straightforward: "A home sale will be considered related to a change in employment if a qualified person's new place of work is at least 50 miles farther from the old home than the old workplace was from that home. This is the same distance rule that applies for the moving expense deduction. The employment change must occur during the taxpayer's ownership and use of the home as a residence.

The new rules allow a partial exclusion for health if "the primary reason is related to a disease, illness or injury" of the home seller or member of the household. If a physician recommends a change in residence for health reasons, that will be sufficient to claim the exclusion.

Home Sale Capital Gains Exclusion Limitations Involving A Principle Residence Acquired Through A 1031 Exchange:

On October 22, 2004, new tax legislation became effective that places a five-year restriction on 1031 exchanges involving a principle residence. A taxpayer who exchanges into a rental property as a replacement property that is later converted into their primary residence, is not allowed to exclude capital gain under the principal residence exclusion rules, unless the sale occurs at least five years from the date of its acquisition. Any taxpayer, who previously acquired their current residence through a tax-deferred exchange within the past three years, will now have to wait at least another two years before selling their home and excluding any capital gain. This assumes the taxpayer meets the two out of five year occupancy test.

Before taking any steps towards a transaction involving possible capital gains tax exclusions, please consult your CPA, attorney or tax advisor.

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