⨁ Introduction to Delayed Exchanges

> §1031 Exchanges are a Powerful Tax Strategy

Tax-deferred exchanges have been a part of the tax code since 1921 and are one of the last significant tax advantages remaining for business owners and taxpayers. One of the key advantages of a §1031 exchange is the ability to dispose of a relinquished property without incurring a capital gain tax liability in the current tax year, thereby allowing the earning power of the deferred taxes to work for the benefit of the taxpayer instead of the government.

> Basic Tax Exchange Requirements

The IRS allows up to a maximum of 180 calendar days between the sale of the relinquished property and the purchase of the replacement property. Within the 180-day exchange period, the taxpayer must also properly identify suitable replacement property or properties by midnight of the 45th calendar day after closing on the sale of the relinquished property. There are a number of requirements which need to be met to qualify for tax deferral under the tax code:

1. Requirement #1: Both the relinquished and replacement property must be held for investment or used in a business. The IRS uses the term “like-kind” to describe the type of real property that qualify for §1031 tax deferral. Virtually any real property held for investment can be exchanged for any other like-kind real property held for investment. This definition covers a vast variety of developed and undeveloped real estate. Properties which are clearly not like-kind real property are an investor’s primary residence or property held for sale. The relinquished and replacement properties need not have identical functions (i.e. both be residential rentals or commercial strip centers). The key issue is that the taxpayer should be able to substantiate that both properties were held for investment.
2. Requirement #2: The IRS requires the taxpayer to identify the replacement property(ies) within 45 days from closing on the sale of a relinquished property. The 45-day identification period begins on the closing date and the replacement property(ies) must be properly identified in a letter signed by the taxpayer. Taxpayers have a number of ways to properly identify properties. They may identify up to three replacement properties without regard to their total fair market value (Three Property Rule). Alternatively, they can identify an unlimited number of replacement properties, if the total fair market value of all properties is not more than twice the value of the property sold (200% Rule). A taxpayer cannot meet either of these rules if they acquire 95% of the aggregate fair market value of all identified replacement properties.
3. Requirement #3: Close on the replacement property by the earliest of either: 180 calendar days after closing on the sale of the relinquished property or the due date for filing the tax return for the year in which the relinquished property was sold (unless an automatic tax-filing extension has been obtained). Example: If a taxpayer closes on the relinquished property sale on December 27th, the exchange period will end on April 15th (assuming this is the due date for their tax return). In this case, the taxpayer would have to close on the replacement property (or file the appropriate extension) by April 15th. A taxpayer may choose to close both transactions within a shorter period of time, but the maximum time period is 180 calendar days.
4. Requirement #4: The most common exchange format, the delayed exchange, requires investors to work with an IRS-approved third-party principal called a qualified intermediary. The qualified intermediary documents the exchange by preparing the necessary paperwork (Exchange Agreement and other documents), holds the exchange proceeds on behalf of the taxpayer, and structures the exchange after an assignment of the sale and purchase contracts by selling the relinquished property and purchasing the replacement property.

Note: To defer all capital gain taxes, a taxpayer must buy like-kind property(ies) of equal or greater value (net of closing costs), reinvesting all net proceeds from the sale of the relinquished property. Any funds not reinvested or any reduction in debt liabilities not made up for with additional cash from the taxpayer is considered boot and is potentially taxable to the extent the taxpayer has a capital gain tax consequence.

> When Are Capital Gain Taxes Paid?

The capital gain taxes on a §1031 exchange are deferred into the future and are only recognized when a taxpayer actually sells the property for cash instead of performing a §1031 exchange. A taxpayer will then generally recognize gain if they have some taxable boot in a partially-deferred exchange. Investors can continue to exchange properties as often and for as long as they wish.

⨁ Delaware Statutory Trusts (DST)

We also work with Delaware Statutory Trusts (DST) when multiple parties want to take advantage of multiple § 1031 exchanges, rather than being forced to do an exchange with existing partners. In that manner each partner/member can set up their own separate § 1031 account in connection with either a buy, or sell, transaction. The DST structure also enables the sponsor of a real estate project to take in a targeted § 1031 investor to facilitate capital accumulation and use the project as the investor’s § 1031 project. An investor that has 1031 exchange money by utilizing the DST structure to enable the § 1031 transaction for the targeted investor.

⨁ Independent Qualified Intermediary

Your Qualified Intermediary needs to be an independent third party, such as this firm. The IRS specifically states that for the two years prior to your § 1031 transaction, your Qualified Intermediary can not be one of the following:

• you
• your attorney
• your tax advisor
• your real estate agent or broker
• your investment banker or broker
• family members

If there is a prior relationship between you and your QI within that two-year period the exchange will be invalid, and therefore become taxable.

⨁ Simultaneous Exchange

A Simultaneous Exchange occurs when both replacement property and relinquished property close on the same day.

It is important to note that the exchange must occur simultaneously; any delay, even a short delay caused by wiring money to an excro company, can result in the disqualification of the exchange and the immediate application of full taxes.

1. Swap or complete a two-party trade, whereby the two parties exchange or “swap” deeds.
2. Three-party exchange where an “accommodating party” is used to facilitate the transaction in a simultaneous fashion for the exchanger.
3. Simultaneous exchange with a qualified intermediary who structures the entire exchange.

⨁ Reverse Exchange

A Reverse §1031 Exchange, also known as a forward exchange, occurs when you acquire a replacement property through an exchange accommodation titleholder before you exchange the property you currently own. In theory, this type of exchange is very simple: you buy first and you exchange later.

What makes reverse exchanges tricky is that they require all cash and many banks won’t offer loans for reverse exchanges. Taxpayers must also decide which of their investment properties are going to be acquired and which will be “parked.” A failure to close on the relinquished property during the established 180 day period that the acquired property is parked will result in a forfeit of the exchange.

The reverse exchange follows many of the same rules as the delayed exchange. However, there are a few key differences to note:

1. Taxpayers have 45 days to identify what property is going to be sold as “the relinquished property.”
2. After the initial 45 days, taxpayers have 135 days to complete the sale of the identified property and close out the reverse 1031 exchange with the purchase of the replacement property

⨁ Construction or Improvement Exchange

The Construction Exchange allows taxpayers to make improvements on the replacement property by using the exchange equity. In other words, the taxpayer can use their tax-deferred dollars to enhance the replacement property while it is placed in the hands of a qualified intermediary for the remainder of the 180 day period.

It's important to note that the taxpayer must also meet three requirements if they want to defer all of the gain (from the sale of the relinquished property) and instead use it as part of the construction or improvement exchange.

1. The entire exchange equity must be spent on completed improvements or as down payment by the 180th day.
2. The taxpayer must receive “substantially the same property” that they identified by the 45th day.
3. The replacement property must be equal or greater in value when it is deeded back to the taxpayer. The improvements must be in place before the taxpayer can take the title back from the qualified intermediary.