1031 Exchange Glossary
We understand there may be a lot of unfamiliar terms used in discussing 1031 exchanges and replacement property. This process can be complicated and filled with technical terms, so we've put together this glossary to help you understand the ins and outs of 1031 exchanges. Whether you're a seasoned investor or just starting out, this resource will help you navigate the complex world of 1031 exchanges and make informed decisions about your investments. From "Qualified Intermediary" to "Relinquished Property," this glossary will provide definitions and explanations of the key terms you need to know. It’s very important to us that we make this process as easy as possible, so please make sure to let us know if you need further explanation or if you ever have questions.
A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction that allows real estate investors to sell one property and purchase another "like-kind" property without paying capital gains taxes on the sale.
To qualify for a 1031 exchange, both the relinquished property (the property being sold) and the replacement property (the property being purchased) must be held for investment or business purposes. The exchange must also meet several other requirements, such as using a qualified intermediary to facilitate the transaction and identifying the replacement property within 45 days of the sale of the relinquished property.
The benefit of a 1031 exchange is that it allows real estate investors to defer paying capital gains taxes on the sale of their property, allowing them to reinvest their funds into a new property and potentially generate more income and profits. However, it's important to note that eventually, the investor will have to pay capital gains taxes on the sale of the replacement property, unless they do another 1031 exchange.
The 45-Day Period is a critical part of the process. This period refers to the time frame in which the investor, after selling the original (relinquished) property, must identify the potential replacement properties they plan to purchase.
This period begins on the day the investor sells their original property and ends exactly 45 days later, regardless of whether these days are weekends or holidays. This deadline is strictly enforced, and missing it could potentially disqualify the entire 1031 exchange process, resulting in significant tax liabilities.
It's also important to note that there are specific rules around the number and value of properties that can be identified during this period. These are often referred to as the "3-property rule," the "200% rule," and the "95% rule." The 45-Day Period is a crucial part of structuring a successful 1031 exchange.
An "accommodator" is a qualified intermediary (QI) who assists taxpayers in completing a tax-deferred exchange of real property. The role of the accommodator is to facilitate the exchange by holding the proceeds from the sale of the taxpayer's relinquished property in a trust or escrow account and then using those funds to acquire replacement property on behalf of the taxpayer.
The accommodator must comply with certain rules and regulations set forth by the Internal Revenue Service (IRS) to ensure that the exchange qualifies for tax deferral. For example, the accommodator must not be a disqualified person, such as a relative or business partner of the taxpayer, and must not have any interest in the property being exchanged.
The use of an accommodator in a 1031 exchange is not required by law, but it is recommended in order to ensure compliance with IRS rules and regulations and to minimize the risk of the exchange being disqualified.
Acquisition cost refers to the total cost incurred by the taxpayer in acquiring a replacement property in a 1031 exchange transaction. This includes the purchase price of the replacement property, as well as any related expenses such as closing costs, title fees, and commissions paid to real estate agents or brokers.
The acquisition cost of the replacement property is important in determining the amount of the deferred gain that can be deferred in the 1031 exchange transaction. To fully defer the gain, the taxpayer must acquire a replacement property with an equal or greater value than the relinquished property and use all the proceeds from the sale of the relinquished property towards the acquisition cost of the replacement property.
It's important to note that any costs that are not directly related to the acquisition of the replacement property, such as repairs or improvements, are not included in the acquisition cost for the purposes of a 1031 exchange.
An "Acquisition Period" refers to the period of time that a taxpayer has to identify and acquire replacement property after selling their original property. Specifically, the Acquisition Period is a 45-calendar-day period that begins on the day the taxpayer sells their relinquished property in a 1031 exchange.
During the Acquisition Period, the taxpayer must identify potential replacement properties in writing to the qualified intermediary (QI) or other designated person handling the exchange. The taxpayer must adhere to strict identification rules and guidelines to ensure that the identified replacement properties meet the requirements for a valid 1031 exchange.
If the taxpayer is unable to identify replacement property or acquire it within the 45-day Acquisition Period, the exchange will fail, and the taxpayer may be liable for taxes on the proceeds from the sale of their relinquished property.
Actual Receipt in the context of the 1031 exchange industry refers to the moment when an exchanger (the taxpayer performing the exchange) physically or constructively takes possession or control of the replacement property during the course of a like-kind exchange.
During a 1031 exchange, the exchanger is required to identify and receive the replacement property within specific timeframes. In most cases, to prevent the exchanger from having actual receipt of the proceeds from the relinquished property, a Qualified Intermediary (QI) is used to facilitate the transaction. Actual receipt of the funds by the exchanger during the exchange process can jeopardize the tax-deferred status of the transaction.
The actual receipt of the replacement property is a crucial step in completing a 1031 exchange. The exchanger is typically required to acquire the replacement property within 180 days of transferring the relinquished property or the due date of the exchanger's tax return for the taxable year in which the transfer of the relinquished property occurs, whichever is earlier.
Adjusted basis refers to the original cost basis of a property, adjusted for various factors such as depreciation, capital improvements, and other expenses incurred by the owner. The adjusted basis is used to calculate the gain or loss on the sale of a property, which is a key factor in determining the tax liability of the property owner.
In a 1031 exchange, the adjusted basis of the property being relinquished is carried over to the replacement property, which means that any deferred taxes on the gain from the relinquished property are also deferred until the replacement property is sold. This can provide significant tax benefits to property owners who want to exchange their property for a similar property without incurring a tax liability.
Adjusted Cost Basis
Adjusted Cost Basis refers to the adjusted cost or tax basis of a property that is being sold or exchanged. The adjusted cost basis is the original cost or purchase price of the property plus any capital improvements, such as renovations or additions, made to the property over time, minus any depreciation taken on the property since its acquisition.
The adjusted cost basis is a critical factor in determining the tax liability and potential capital gains of a property. By properly calculating the adjusted cost basis, investors can accurately determine their tax liability when selling or exchanging a property and ensure they are complying with the 1031 exchange regulations. It is important to work with a tax professional or qualified intermediary to accurately calculate the adjusted cost basis and navigate the 1031 exchange process.
Adjusted Gross Income (AGI)
Adjusted Gross Income (AGI) is a term used in U.S. tax law to describe an individual's total gross income, minus certain allowable deductions such as contributions to a retirement account or student loan interest payments. In the context of a 1031 exchange, AGI is relevant because it can impact the investor's ability to take advantage of tax benefits associated with the exchange.
For example, to qualify for a 1031 exchange, an investor must meet certain criteria related to the value of the properties being exchanged and the timing of the transaction. Additionally, if the investor's AGI is above a certain threshold, they may not be eligible for certain tax benefits associated with the exchange, such as the ability to defer capital gains taxes.
Therefore, investors engaging in 1031 exchanges may need to carefully consider their AGI and any potential impact it may have on their tax liability. It is always advisable to consult with a qualified tax professional to determine the best strategy for maximizing the tax benefits of a 1031 exchange.
Balancing the Exchange
A balanced exchange ensures that the taxpayer defers 100% of his or her taxes on capital gain and depreciation recapture. To achieve a balanced exchange one must:
- acquire a replacement property that is equal to or greater value than the relinquished property;
- reinvest all of the net equity from the relinquished property in the replacement property; and
- assume debt on the replacement property that is equal to or greater than the debt on the replacement property or contribute cash to make up the deficiency.
In the context of a 1031 exchange, a bargain sale refers to a transaction in which the seller of real estate or personal property sells the asset to a buyer at a price below its fair market value. The seller then donates the difference between the sale price and the fair market value to a charity, which can provide the seller with a tax deduction.
A bargain sale can be used as part of a 1031 exchange, which is a tax-deferred exchange that allows real estate investors to defer paying capital gains taxes on the sale of a property if they reinvest the proceeds in another like-kind property. By using a bargain sale in a 1031 exchange, the seller can reduce their capital gains tax liability while also making a charitable donation.
In the context of a 1031 exchange, "basis" refers to the original purchase price of the property that is being sold, plus any capital improvements made to the property during the time the owner held it. The basis is used to calculate the amount of taxable gain that the owner will realize upon the sale of the property and thus plays a critical role in determining the tax consequences of a 1031 exchange transaction.
In a 1031 exchange, the basis of the property that is being sold is transferred to the replacement property acquired in the exchange. This means that the owner's tax liability is deferred, rather than eliminated, as the basis of the replacement property is reduced by the amount of gain that was deferred in the exchange.
It is important for those involved in a 1031 exchange transaction to have a clear understanding of basis, as it can have significant tax implications for the owner. Working with a qualified intermediary and/or tax professional can help ensure that all aspects of the exchange, including basis, are properly accounted for and managed.
A Basis Swap is a type of transaction that can be used in a 1031 exchange, which is a tax-deferred exchange of like-kind properties that allows real estate investors to defer paying capital gains taxes on the sale of a property.
In a Basis Swap, the investor exchanges a property with a low-cost basis for a property with a higher-cost basis. This can be advantageous because the cost basis of a property determines the amount of capital gains taxes owed when the property is sold. By exchanging a low-cost basis property for a high-cost basis property, the investor can reduce their potential tax liability when they eventually sell the property.
It's important to note that Basis Swaps are just one of many strategies that can be used in a 1031 exchange, and the specific tax implications can vary depending on the individual circumstances of the exchange. It's always recommended to consult with a tax professional or financial advisor before making any decisions related to a 1031 exchange.
Boot refers to the non-like-kind property received by the taxpayer in the exchange. When a taxpayer completes a 1031 exchange, they are required to exchange their relinquished property for like-kind property of equal or greater value. If the value of the replacement property is less than the value of the relinquished property, the taxpayer may receive cash or other property in addition to the replacement property. This additional property or cash received by the taxpayer is known as "boot."
Boot is typically subject to capital gains tax and may also be subject to depreciation recapture tax, depending on the circumstances of the exchange. The tax consequences of receiving boot in a 1031 exchange can be complex, and it is important for taxpayers to consult with a qualified tax advisor before completing a 1031 exchange that involves boot.
Boot Netting Rules
- Cash boot paid offsets cash boot received
- Cash boot paid offsets mortgage boot received (debt relief)
- Mortgage boot paid (debt assumed) offsets mortgage boot received
- Mortgage boot paid does not offset cash boot received
Refers to the situation in which the taxpayer intentionally receives boot in a 1031 exchange to offset other gains, resulting in the transaction being partially taxable.
A Build-to-Suit Exchange, also known as a "Construction Exchange" or a "Build-to-Suit Improvement Exchange," is a type of 1031 exchange that allows a taxpayer to use the proceeds from the sale of a relinquished property to construct or improve a replacement property that is tailored to their specific needs.
In a Build-to-Suit Exchange, the taxpayer identifies a qualified intermediary who holds the proceeds from the sale of their relinquished property in a segregated account. The taxpayer then identifies a replacement property and enters into an agreement with a qualified third party (known as the "Build-to-Suit Facilitator") to construct or improve the replacement property to their specifications.
The Build-to-Suit Facilitator holds title to the replacement property during the construction or improvement period, and once the improvements are complete, the taxpayer acquires the replacement property from the Build-to-Suit Facilitator using the proceeds from the sale of their relinquished property. The taxpayer must complete the acquisition of the replacement property within the 180-day period allowed under the 1031 exchange rules.
Overall, a Build-to-Suit Exchange can provide a taxpayer with greater flexibility and control over the replacement property they acquire, as well as the ability to customize the property to their specific needs. However, it is important to consult with a qualified tax professional to ensure that a Build-to-Suit Exchange is the right strategy for a particular situation and to comply with all applicable tax laws and regulations.
A "Built-to-Suit Exchange" is a type of 1031 exchange, which refers to a section of the U.S. Internal Revenue Code that allows for the tax-deferred exchange of like-kind properties.
In a Built-to-Suit Exchange, the replacement property is constructed or improved according to the specific needs and requirements of the exchanger (the person or entity initiating the exchange). This type of exchange allows the exchanger to acquire a replacement property that better suits their business needs or investment objectives, while still deferring taxes on any capital gains from the sale of the relinquished property.
To qualify as a Built-to-Suit Exchange, the exchanger must work with a Qualified Intermediary (QI) and follow the rules and regulations of the 1031 exchange process, including identifying replacement properties within 45 days and completing the exchange within 180 days. The improvements to the replacement property must also be completed before the end of the exchange period.
The exchangor’s right to receive money or other property must be limited. These limitations provide that the exchangor may not, pursuant to the documentation, have a right to receive money or non-like-kind property until the earlier of— the end of the identification period (if the exchangor has not identified any replacement property within 45 days); the receipt by the exchangor of all of the identified replacement property (or that for which identification has subsequently failed due to an unfulfilled material and substantial written contingency, such as zoning approval); or the expiration of the 180-day reinvestment period for a calendar-year exchangor.
This could result in a one-year tax deferral of recognizing the boot received for any exchange by an individual after July 4 because the receipt of the non-like-kind property occurs in the following taxable year. This deferral also applies to a failed exchange begun after this midyear date if the property was properly identified but never acquired for bona fide reasons during the 180 days that followed.
Regardless of whether the exchangor subsequently receives money or boot from the QI at the end of an exchange, IRS Form 1099-S box 2 should be 0, and box 4 should be checked.
A capital gain refers to the profit that an investor makes from the sale of an investment property that has appreciated in value over time. This capital gain is typically subject to taxes, but by utilizing a 1031 exchange, investors can defer those taxes by reinvesting the proceeds from the sale into another like-kind property.
To qualify for a 1031 exchange, the new property must be similar in nature and purpose to the old property, and the entire proceeds from the sale must be reinvested into the new property. By deferring the capital gains taxes through a 1031 exchange, investors can continue to grow their real estate investments without having to pay taxes on the gains until they sell the new property.
Capital Gain or Loss
A capital gain or loss refers to the difference between the amount paid for a property and the amount received when it is sold. If the selling price is higher than the purchase price, the taxpayer has a capital gain, and if the selling price is lower than the purchase price, the taxpayer has a capital loss.
In a 1031 exchange, the capital gain or loss on the relinquished property is deferred rather than realized, meaning that the taxpayer does not have to pay taxes on the gain or loss at the time of the sale. Instead, the gain or loss is carried forward and applied to the replacement property acquired in the exchange. This can provide significant tax benefits to taxpayers who are looking to sell one property and acquire another.
Capital Gain Tax
Capital Gain Tax refers to the tax imposed on the profit realized from the sale of an asset that has increased in value over time. In the context of a 1031 exchange, a capital gain tax would apply to the difference between the sale price of the original property and its adjusted basis (i.e., the original cost plus any capital improvements made during ownership).
However, if the property owner uses the proceeds from the sale of the original property to acquire a like-kind replacement property through a 1031 exchange, they may be able to defer paying capital gain taxes on the sale of the original property until the sale of the replacement property. This allows them to reinvest the full sale proceeds into the new property, thus maximizing their investment potential.
Capital gains refer to the profits that an investor realizes when they sell an asset, such as real estate, stocks, or bonds, at a price higher than their original purchase price. In the context of a 1031 exchange, capital gains tax is an important consideration as it can be deferred by reinvesting the profits from the sale of a property into a like-kind property through the exchange process.
The 1031 exchange industry is a tax strategy that allows investors to defer paying capital gains taxes on the sale of a property by reinvesting the proceeds in a similar type of property. This can be a valuable tool for real estate investors looking to maximize their profits while minimizing their tax liabilities. The goal of a 1031 exchange is to allow investors to exchange one investment property for another without triggering a taxable event, thereby deferring the payment of capital gains taxes until a later date.
Capital improvements refer to any permanent improvements made to a property that add to its value, increase its useful life, or adapt it to new uses. Capital improvements can include a wide range of renovations, such as adding a new roof, installing new plumbing or electrical systems, replacing flooring, or updating the building's exterior.
The cost of these improvements is added to the property's basis, which is the original purchase price plus the cost of any capital improvements. This increased basis can reduce the amount of taxable gain realized on the sale of the property and can also help investors qualify for a 1031 exchange by demonstrating that the property is being held for productive use in a trade or business or for investment purposes.
Cash equivalence refers to any property or asset that is treated as cash for the purposes of the exchange. This means that the property or asset can be used to satisfy the requirement for the taxpayer to identify and acquire replacement property within a certain timeframe as part of a 1031 exchange, just as if they had used cash.
Examples of cash equivalent assets that can be used in a 1031 exchange include:
- Certificates of deposit (CDs)
- Money market accounts
- Treasury bills and notes
- Short-term bonds
- Marketable securities
It's important to note that not all assets can be used as cash equivalents in a 1031 exchange. For example, stock in a closely held corporation or ownership in a limited liability company (LLC) may not qualify as a cash equivalent. It is important to consult with a qualified tax professional to determine which assets can be used as cash equivalents in a 1031 exchange.
Cash flow refers to the net amount of cash and cash-equivalent assets that flow in and out of a 1031 exchange property. It takes into account all of the income generated by the property, as well as any expenses associated with owning and managing the property. This includes rental income, operating expenses, mortgage payments, and taxes. Understanding the cash flow of a property is important in a 1031 exchange because it can impact the amount of potential gain or loss realized by the taxpayer. If a replacement property has a positive cash flow, it can help offset any potential losses from the relinquished property, while a negative cash flow may result in additional expenses for the taxpayer. It is important for taxpayers to carefully evaluate the cash flow of any potential replacement property before making a decision in a 1031 exchange.
Closing costs refer to the fees and expenses associated with the transfer of ownership of a property from one party to another in a 1031 exchange transaction. These costs typically include title search and insurance, recording fees, appraisal fees, loan origination fees, inspection fees, and other charges related to the transfer of property ownership.
In a 1031 exchange, the buyer and seller typically share the closing costs, and they can be paid out of the proceeds from the sale of the relinquished property or from the funds held by the qualified intermediary (QI) during the exchange process. It is important for investors to understand the potential closing costs associated with a 1031 exchange when evaluating the financial feasibility of a transaction.
Combined Income and Capital Gain Tax Rates
Combined income and capital gain tax rates refer to the total tax rate applied to both types of income when calculating taxes owed on a 1031 exchange. In a 1031 exchange, capital gains tax can be deferred by reinvesting proceeds into another like-kind property.
However, any profit made on the sale of the property will still be subject to tax at the taxpayer's combined income and capital gain tax rate. This rate is determined by adding the taxpayer's ordinary income tax rate and the capital gains tax rate, which can vary depending on the taxpayer's income level and other factors.
Commercial property refers to real estate that is used for business or investment purposes, such as office buildings, retail spaces, industrial properties, and multi-family residential buildings. In the context of a 1031 exchange, commercial property is a type of like-kind property that can be exchanged for another qualifying commercial property without triggering immediate capital gains taxes.
A 1031 exchange, also known as a like-kind exchange, is a tax-deferred transaction that allows an investor to sell one investment property and use the proceeds to purchase another like-kind property. By doing so, the investor can defer paying capital gains taxes on the sale of the first property until they sell the replacement property. To qualify for a 1031 exchange, both the original property and the replacement property must be held for business or investment purposes and must be of like-kind.
Constructive Receipt is a concept within the 1031 exchange industry, which refers to the point at which a taxpayer is considered to have gained control or access to the proceeds from the sale of a relinquished property, even if they have not physically received the funds. This is a crucial consideration in the context of a 1031 exchange, as the primary goal of such an exchange is to defer capital gains tax liability through the reinvestment of proceeds from the sale of a property into a like-kind property.
In order to successfully complete a 1031 exchange and avoid constructive receipt, the taxpayer must follow specific guidelines and procedures, including the use of a qualified intermediary (QI) to hold and manage the funds from the sale of the relinquished property. The QI then transfers the funds directly to the seller of the replacement property at the time of closing, ensuring that the taxpayer does not have direct access or control over the funds during the exchange process. By avoiding constructive receipt, the taxpayer can defer capital gains taxes on the transaction and potentially achieve other financial and investment benefits.
a cooperation clause refers to a provision that is often included in the purchase agreement between the buyer and seller of the properties being exchanged. This clause requires both parties to cooperate with each other and with the qualified intermediary (QI) who is facilitating the 1031 exchange.
The cooperation clause typically includes provisions related to the transfer of documents, funds, and other information necessary to complete the exchange. It may also require the parties to take certain actions, such as signing necessary paperwork, providing notices to relevant parties, or executing necessary agreements, to ensure the exchange can be completed in a timely and efficient manner.
The cooperation clause is important in the 1031 exchange process because it helps to ensure that all parties involved work together to complete the transaction successfully. Without this clause, one party may be able to delay or disrupt the exchange, which could result in negative consequences for all parties involved.
The "cost basis" refers to the original purchase price of a property, plus any costs associated with acquiring, improving, or selling it.
When a property owner decides to participate in a 1031 exchange, they are deferring the payment of capital gains tax by reinvesting the proceeds from the sale of a property into a "like-kind" property. The cost basis of the original property is used to calculate the amount of capital gains tax that would be owed if the property were sold outright instead of being exchanged.
For example, if an investor originally purchased a property for $500,000 and then spent an additional $50,000 on renovations, their cost basis would be $550,000. If they sell the property for $700,000 and reinvest the proceeds into a like-kind property through a 1031 exchange, they would only owe capital gains tax on the difference between the selling price and the cost basis ($700,000 - $550,000 = $150,000).
Debt service refers to the amount of money required to make mortgage payments on a property, including principal and interest.
When a property owner decides to participate in a 1031 exchange, they may choose to use some or all of the proceeds from the sale of their property to acquire a replacement property. If they choose to finance the replacement property with a mortgage, the debt service on that mortgage is an important factor to consider.
The debt service is typically calculated on a monthly basis and is based on the outstanding principal balance of the mortgage, as well as the interest rate and loan term. Property owners should carefully consider the debt service of any potential replacement property to ensure that it is manageable and fits within their overall investment strategy.
Deduction refers to the reduction of the tax basis of the replacement property by any expenses or costs associated with the exchange. When a taxpayer engages in a 1031 exchange, they are essentially swapping one investment property for another, deferring the payment of capital gains tax on the transaction. However, the cost of the exchange itself, such as fees paid to a qualified intermediary or transaction costs, cannot be included in the tax basis of the replacement property. Instead, these costs are deducted from the tax basis, reducing the overall amount of tax deferral. The deduction is subtracted from the adjusted tax basis to calculate the taxable gain or loss upon the eventual sale of the replacement property.
A deemed exchange refers to a transaction that is treated as a tax-deferred exchange under Section 1031 of the Internal Revenue Code, even though there is not a simultaneous exchange of properties between the parties involved.
In a deemed exchange, the taxpayer may sell their relinquished property to a buyer and then subsequently identify and acquire replacement property from a different seller within the specified time frame. This transaction is treated as an exchange, even though the taxpayer did not directly exchange properties with the buyer of the relinquished property.
To qualify as a deemed exchange, the transaction must meet certain requirements, such as adhering to the identification and exchange period timelines and using a qualified intermediary to facilitate the exchange. By completing a deemed exchange, the taxpayer may defer capital gains taxes that would otherwise be due upon the sale of the relinquished property.
A deferred exchange, also known as a "delayed exchange" or "Starker exchange," is a type of tax-deferred exchange under section 1031 of the Internal Revenue Code.
In a deferred exchange, the taxpayer (referred to as the "exchanger") sells their relinquished property and then uses the proceeds to purchase a replacement property within a certain timeframe. The key feature of a deferred exchange is that the exchanger does not receive the proceeds from the sale of the relinquished property directly, but instead, they are held in a qualified intermediary's escrow account until the replacement property is purchased.
The deferred exchange allows the exchanger to defer paying capital gains taxes and other taxes that would normally be due upon the sale of the relinquished property. By reinvesting the proceeds into a replacement property, the exchanger is able to continue deferring taxes until they eventually sell the replacement property, at which point they will owe taxes on the entire amount of accumulated gain from both the relinquished and replacement properties.
To qualify for a deferred exchange, the exchanger must meet certain requirements, including identifying a replacement property within 45 days of the sale of the relinquished property and completing the exchange within 180 days.
Deferred Sales Trust
A deferred sales trust (DST) is a financial strategy used in real estate investing that allows the seller to defer capital gains taxes by transferring the property to a trust. The DST is designed to provide the seller with greater flexibility in managing the proceeds from the sale of their property, including investing in a diversified portfolio of assets.
Unlike a traditional 1031 exchange, which requires the seller to identify and purchase a replacement property within a strict timeline, a DST allows the seller to transfer the proceeds to a trust and invest in a wider range of assets, such as stocks, bonds, and mutual funds. This flexibility allows the seller to potentially generate a higher return on investment and better manage their cash flow needs.
One of the key benefits of a DST is the ability to defer capital gains taxes for a longer period of time compared to a 1031 exchange. This is because the DST is not subject to the same strict timelines as a 1031 exchange and can be structured to defer taxes for up to 30 years.
However, a DST can be more complex and expensive to set up than a 1031 exchange, and it may not be suitable for all sellers. It is important to consult with a qualified financial advisor or tax professional to determine if a DST is the right strategy for your specific situation.
A delayed exchange (also known as a "Starker exchange" or a "forward exchange") refers to a type of tax-deferred exchange in which the taxpayer sells their investment property and uses the proceeds to purchase a replacement property, all while deferring the payment of capital gains taxes that would normally be due upon the sale of the original property.
In a delayed exchange, the taxpayer has 45 days from the sale of their original property to identify a replacement property and 180 days to complete the purchase of the replacement property. The taxpayer must use a qualified intermediary to hold the proceeds from the sale of the original property and facilitate the purchase of the replacement property.
By completing a delayed exchange, the taxpayer is able to defer the payment of capital gains taxes and potentially defer any depreciation recapture taxes that would have been due upon the sale of the original property. Delayed exchanges are a popular tool among real estate investors who want to defer taxes and reinvest their gains into new properties.
A depreciable property refers to any property that is used in a trade or business or held for investment purposes, and which has been subject to depreciation deductions for tax purposes. Examples of depreciable properties may include buildings, machinery, vehicles, and other tangible assets.
In a 1031 exchange, the term "like-kind" refers to the requirement that the property being exchanged must be of the same nature or character as the property being sold. Therefore, a depreciable property can be exchanged for another depreciable property, as long as both properties are of the same nature or character.
It's important to note that the tax rules for 1031 exchanges can be complex, and it's recommended to consult with a qualified tax professional before engaging in any such transactions.
Depreciation is a term used in the 1031 exchange industry to refer to the reduction in the value of a property over time due to wear and tear, deterioration, and obsolescence. It is an accounting concept that allows property owners to account for the declining value of their investment property as a tax deduction.
In the context of a 1031 exchange, depreciation plays an important role in calculating the property's adjusted basis, which is used to determine the amount of gain or loss that will be recognized for tax purposes upon the sale of the property. The adjusted basis is calculated by subtracting the total amount of depreciation claimed on the property from the original purchase price.
When a property owner sells a property as part of a 1031 exchange, any accumulated depreciation that was previously claimed must be recaptured and taxed as ordinary income, up to a maximum rate of 25%. However, by completing a 1031 exchange and acquiring a replacement property, the property owner can defer paying taxes on the recaptured depreciation and any other gains from the sale of the relinquished property.
The decrease in value of an asset over time, used for tax purposes.
Depreciation recapture is a tax concept that can come into play when a property owner sells an asset that has been depreciated for tax purposes. In the context of a 1031 exchange, which allows for the tax-deferred exchange of like-kind properties, depreciation recapture can affect the tax consequences of the transaction.
Depreciation is a tax deduction that allows property owners to deduct a portion of the cost of an asset over its useful life. When the property is sold, any gain realized from the sale may be subject to depreciation recapture, which means that the tax on the gain is calculated as if the depreciation deduction had not been taken.
In a 1031 exchange, if the property being sold has been depreciated, the amount of depreciation that has been taken must be recaptured and recognized as taxable income, even if the owner is exchanging the property for another like-kind property. This means that the owner may owe taxes on the recaptured depreciation even if they are not taking any cash out of the transaction.
However, if the property owner uses the proceeds from the sale to purchase another like-kind property in a 1031 exchange, they can defer paying taxes on the gain, including the recaptured depreciation, until the new property is sold.
A designated entity refers to a qualified intermediary (QI) or an exchange accommodation titleholder (EAT) who is authorized to facilitate the exchange of like-kind properties between the buyer and seller.
As per the IRS regulations, the seller of a property must transfer the proceeds from the sale to a QI or EAT, who then holds the funds until they can be used to acquire a replacement property. The QI or EAT acts as a neutral third party and ensures that the exchange is conducted in accordance with the rules and regulations of Section 1031 of the Internal Revenue Code.
In short, a designated entity is a crucial participant in a 1031 exchange, responsible for holding and transferring the funds and ensuring that the exchange is conducted in compliance with the IRS regulations.
A direct deed refers to the legal document that transfers the ownership of a property from the seller (relinquishing party) to the buyer (acquiring party) in a 1031 exchange transaction.
In a 1031 exchange, the direct deed is important because it is used to convey title of the relinquished property to the buyer, who will then transfer that title to the qualified intermediary (QI) or accommodator, who will hold it until the replacement property is purchased. Once the replacement property is acquired, the QI will transfer the title to the acquiring party by way of another direct deed.
The use of a direct deed in a 1031 exchange transaction helps to ensure that the transfer of the relinquished property and the acquisition of the replacement property are properly documented and legally sound, which can help to minimize the risk of any disputes or legal challenges arising down the line.
A practice authorized by Treasury Revenue Ruling 90-34 whereby either the relinquished property or the replacement property can be deeded directly from seller to buyer without deeding the property to the Qualified Intermediary.
Disposition refers to the act of selling or transferring the relinquished property, which is the property the taxpayer currently owns and intends to exchange for a like-kind property.
A disposition occurs when the taxpayer transfers legal ownership of the relinquished property to a buyer or other entity, typically in exchange for cash or other consideration. The disposition is a critical step in the 1031 exchange process, as it triggers the start of the 45-day identification period during which the taxpayer must identify potential replacement properties.
It is important to follow the rules and guidelines for disposing of property in a 1031 exchange, as failure to do so can result in tax consequences and potential disqualification of the exchange.
Due diligence is a crucial part of the 1031 exchange industry that involves conducting a thorough investigation and analysis of a potential replacement property before completing a 1031 exchange transaction.
During due diligence, a taxpayer and their qualified intermediary will typically review and verify important information about the replacement property, such as its title, condition, location, and potential income and expenses. This process can also include inspections, appraisals, and assessments of any potential risks or liabilities associated with the property.
The purpose of due diligence is to ensure that the taxpayer fully understands the risks and benefits of the replacement property and can make an informed decision about whether or not to proceed with the exchange. It also helps to minimize the potential for any surprises or unexpected issues to arise after the exchange is complete.
Equity refers to the amount of ownership that an investor has in a property, calculated as the property's fair market value minus any outstanding mortgages or other liens.
During a 1031 exchange, an investor can sell a property and defer paying taxes on the capital gains if they use the proceeds to purchase another like-kind property. The equity from the original property can then be transferred to the replacement property.
For example, if an investor owns a property worth $1 million and has a mortgage of $500,000, their equity in the property is $500,000. If they sell this property for $1.5 million and use the proceeds to purchase another like-kind property for $1.5 million or more, they can defer paying taxes on the capital gains. The equity from the original property ($1 million minus the $500,000 mortgage) can then be transferred to the replacement property.
The value of a property minus any outstanding debt or liens.
An exchange refers to a tax-deferred exchange of certain types of investment properties, as authorized under Section 1031 of the Internal Revenue Code. In a 1031 exchange, the owner of an investment property can sell it and use the proceeds to purchase another "like-kind" investment property, without triggering a tax liability on the capital gains from the sale.
To facilitate a 1031 exchange, the investor typically works with a qualified intermediary (QI) or exchange facilitator, who holds the funds from the sale of the original property and transfers them to the seller of the replacement property, ensuring that the exchange meets the IRS's requirements for tax deferral. The exchange industry consists of professionals and firms that provide various services related to 1031 exchanges, including QIs, attorneys, accountants, real estate brokers, and other intermediaries.
Exchange Accommodation Titleholder (EAT)
An Exchange Accommodation Titleholder (EAT) is a legal entity that temporarily holds title to both the relinquished property being sold by the taxpayer and the replacement property being purchased by the taxpayer in a like-kind exchange. The EAT serves as a "middleman" in the transaction, allowing the taxpayer to sell their relinquished property and acquire their replacement property without triggering a tax liability on the transaction.
The EAT structure is commonly used in situations where there is a timing gap between the sale of the relinquished property and the purchase of the replacement property, or where there are other complexities that make it difficult for the taxpayer to directly exchange properties with another party. The EAT holds the title to the replacement property during the interim period and then transfers it to the taxpayer once the sale of the relinquished property is complete.
The use of an EAT in a 1031 exchange requires careful planning and adherence to specific IRS guidelines to ensure that the transaction is considered a valid exchange and not a taxable sale.
In a 1031 exchange, an exchange agreement is a legal document that outlines the terms and conditions of the exchange between the taxpayer (also known as the "exchanger") and the qualified intermediary (QI) or accommodator facilitating the transaction. The exchange agreement typically includes information such as the identification of the relinquished property, the identification of the replacement property, and the timeline for completing the exchange.
The exchange agreement is an essential component of a 1031 exchange as it sets out the responsibilities and obligations of the parties involved and helps ensure that the transaction is structured in a way that complies with IRS regulations. In addition to the exchange agreement, other documents, such as a purchase agreement for the replacement property and a deed transferring the relinquished property, may also be required to complete the exchange.
It is important for taxpayers to carefully review and understand the exchange agreement and any related documents before entering into a 1031 exchange to ensure that they fully understand their obligations and responsibilities throughout the transaction.
Exchange Funds Account
The account is established by the qualified intermediary to hold the exchange funds.
The period of time during which the exchangor must complete the acquisition of the replacement property in his or her tax-deferred, like-kind exchange transaction. The exchange period is 180 calendar days from the transfer of the exchangor’s first relinquished property, or the due date (including extensions) of the exchangor’s income tax return for the year in which the tax-deferred, like-kind exchange transaction took place, whichever is earlier and is not extended due to holidays or weekends.
Exchangor / Exchanger
The owner of the investment property looking to make a tax-deferred exchange. The taxpayer who is completing the tax-deferred, like-kind exchange transaction. An exchangor may be an individual, partnership, LLC, corporation, institution, or business.
The rules for like-kind exchanges do not apply to property held for personal use (such as homes, boats, or cars); cash; stock in trade, or other property held primarily for sale (such as inventories, raw materials, and real estate held by dealers); stocks, bonds, notes or other securities or evidence of indebtedness (such as accounts receivable); partnership interests; certificates of trust or beneficial interest.
Fair Market Value
The price that a property would sell for under normal market conditions.
A 1031 exchange in which the taxpayer acquires the replacement property before selling the relinquished property.
An undivided fractional interest or partial interest in the property. See also Tenant-In-Common Interest.
A form of ownership in which multiple individuals or entities own a share of a property.
Fully Taxable Exchange
A 1031 exchange in which the taxpayer receives boot that cannot be offset by other losses or expenses, resulting in the transaction being fully taxable.
The time period begins upon the close of escrow of the relinquished property. During this 45-day period, the exchangor must identify the replacement property in order to continue with the section 1031 exchange transaction. The period is 45 calendar days from the transfer of the exchangor’s relinquished property and is not extended due to holidays or weekends.
The form is used to remove previously identified replacement property within the identification period of 45 days. The exchangor may change the properties identified at any time and as many times as desired during the 45-day identification period, but may not change the identified properties after the 45-day time period.
Guidelines must be followed when making a 1031 exchange. The exchanger must select one of the following:
Three Property Rule – The Exchangor may identify up to three properties, without regard to their value.
200% Percent Rule – The Exchangor may identify more than three properties, provided their combined fair market value does not exceed 200% of the value of the relinquished property.
95% Percent Rule – The exchanger may identify any number of properties, without regard to their value, provided the exchanger acquires 95% of the fair market value of the properties identified.
An Identification Statement form is used to identify potential replacement property within the 45-day identification period.
An Improvement Exchange, also known as a "Build-to-Suit" or "Construction" exchange, is a type of like-kind exchange where an investor exchanges an existing property for a new property that is currently under construction or that is going to be built.
Property that is improved by the taxpayer after acquisition, which may qualify for a 1031 exchange.
For land or buildings, improvements (also known as capital improvements) are the expenses of permanently upgrading your property rather than maintaining or repairing it. Instead of taking a deduction for the cost of improvements in the year paid, you add the cost of the improvements to the basis of the property. If the property you improved is a building that is being depreciated, you must depreciate the improvements over the same useful life as the building.
Property that is of the same nature, character, or class as the relinquished property in a 1031 exchange.
A sale of property in which the seller receives payment over time, rather than in a lump sum.
Property that does not have a physical presence, such as patents, trademarks, or copyrights.
An unrelated party participates in the tax-deferred, like-kind exchange to facilitate the disposition of the exchangor’s relinquished property and the acquisition of the exchangor’s replacement property. The Intermediary has no economic interest except for any compensation (exchange fee) it may receive for acting as an Intermediary in facilitating the exchange as defined in Section 1031 of the Internal Revenue Code. The Intermediary is technically referred to as the Qualified Intermediary (QI), but is also known as the accommodator or facilitator.
Replacement property acquired in an exchange must be “like-kind” to the property being relinquished. All qualifying real property located in the United States is like-kind. Personal property that is relinquished must be either like-kind or like-class to the personal property which is acquired. Property located outside the United States is not like-kind to property located in the United States.
A synonym for a 1031 exchange.
Like-Kind Personal Property
Personal Property is any property belonging to the Exchangor that is not real estate. The “Like Kind” Rules are more restrictive on personal property exchanges. For example, You can exchange a 4-engine airplane for a 4-engine airplane but not for a 2-engine airplane. You can exchange a painting for a painting, but not for a piece of sculpture, even though both are considered pieces of art. See Personal Property Exchange.
The properties involved in a tax-deferred exchange must be similar in nature or characteristics. Like-kind real estate property is basically any real estate that isn’t your personal residence or a second home. Property that is exchangeable with another property. Refers to the nature or character of the property and not to its grade or quality.
A loan used to purchase property, which is secured by a lien on the property.
Mortgage Boot consists of liabilities assumed or given up by the taxpayer. The taxpayer pays mortgage boot when he assumes or places debt on the replacement property. The taxpayer receives a mortgage boot when he is relieved of debt on the replacement property. If the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off, they are considered to be relieved of debt. The debt relief portion is taxable unless offset when netted against other boots in the transaction.
A 1031 exchange in which the taxpayer exchanges multiple properties for a single replacement property, or vice versa.
Multiple Property Exchange
Disposition and/or acquisition of more than one property in a Section 1031 Exchange.
A lease in which the tenant is responsible for paying operating expenses, such as property taxes, insurance, and maintenance.
An individual or entity that holds legal title to property on behalf of another party.
A transfer of property that is not eligible for a 1031 exchange, such as a sale of personal property.
A loan in which the lender cannot seize any assets beyond the property securing the loan in the event of default.
Refers to the first use of a property, which may disqualify the property from a 1031 exchange if it has not been used for investment or business purposes.
When an exchange entails a combination of the boot with partial success of the exchange. When an exchangor receives some cash from an exchange, excluded property and/or non-like-kind property and/or any net reduction in debt (mortgage relief) on the replacement property as well as an exchange of qualified, like-kind property. In the case of a partial exchange, tax liability would be incurred on the non-qualifying portion and capital gain deferred on the qualifying portion under Section 1031.
A 1031 exchange in which a partnership exchanges property for another property, with each partner receiving a proportional share of the replacement property.
Income generated from investments, such as rental income from real estate, in which the investor does not actively participate.
Any property that is not considered real property, such as furniture or equipment.
Personal Property Exchange
A tax-deferred transfer of personal property (relinquished property) for other personal property (replacement property) that are of like-kind or like-class to each other. See Like-Kind Personal Property.
Phase 1 (Down Leg)
The process in which the relinquished property is sold and all respective paperwork for that process is completed. This process is also known as the “down leg” of the tax-deferred exchange process.
Phase 2 (Up Leg)
The process in which the replacement property is bought and all the respective paperwork for that process is completed. This process is also known as the “up leg” of the tax-deferred exchange process.
Interest paid on a loan from a foreign entity that is exempt from U.S. tax.
Principal Residence Exception
Exclusion from capital gain tax on the sale of principal residence of $250,000 for individual taxpayers and $500,000 for couples, filing jointly, under IRS Section 121. Property must have been the principal residence of the taxpayer(s) 24 months out of the last 60 months. In the case of a dual-use property, such as a ranch, retail store, duplex, or triplex, the taxpayer can defer taxes on the portion of the property used for business or investment under Code Section 1031 and exclude capital gain on the portion used as the primary residence under Section 121.
Both the relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired for immediate resale will not qualify. The taxpayer’s personal residence will not qualify.
Qualified Escrow Account
An escrow account, wherein the escrow agent (QI) is not the exchangor or a disqualified person and that limits the Exchangors rights to receive, pledge, borrow or otherwise obtain the benefits of the tax-deferred, like-kind exchange cash balance and/or other assets from the sale of the relinquished property in compliance with the Treasury Regulations. The Qualified Escrow Account also ensures that the exchangor’s exchange funds and/or assets are held as fiduciary funds and are therefore protected against claims from potential creditors of the Qualified Intermediary.
Qualified Exchange Accommodation Agreement
The contractual arrangement between the exchangor and the Exchange Accommodator Titleholder whereby the EAT holds a parked property pursuant to Revenue Procedure 2000-37.
A Qualified Intermediary is an independent party who facilitates tax-deferred exchanges pursuant to Section 1031 of the Internal Revenue Code. The QI cannot be the taxpayer or a disqualified person.
- Acting under a written agreement with the taxpayer, the QI acquires the relinquished property and transfers it to the buyer.
- The QI holds the sales proceeds, to prevent the taxpayer from having actual or constructive receipt of the funds.
- Finally, the QI acquires the replacement property and transfers it to the taxpayer to complete the exchange within the appropriate time limits.
A third-party intermediary that facilitates a 1031 exchange.
An exchangor must intend to use the property in their trade or business, to hold the property for investment, or to hold the property for income production in order to satisfy the qualified use test. Real property: land and buildings (improvements), including but not limited to homes, apartment buildings, shopping centers, commercial buildings, factories, condominiums, leases of 30 years or more, quarries, and oil fields. All types of real property are exchangeable for all other types of real property. In general, state law determines what constitutes real property.
Certain types of property are specifically excluded from Section 1031 treatment. In general, if the property is not specifically excluded, it can qualify for tax-deferred treatment.
Examples of excluded properties:
- property held primarily for sale
- stocks, bonds, or notes
- other securities or evidence of indebtedness
- interests in a partnership
- certificates of trusts or beneficial interest
Real Estate Exchange
Exchange of real property for real property. All types of real properties are like-kind for other real properties, including agricultural land, residential, commercial, and even long-term leases.
Land and any structures or improvements permanently attached to the land.
Realized gain is the increase in the taxpayer’s economic position as a result of the exchange. In a sale, tax is paid on the realized gain.
Recognized gain is the taxable gain. Recognized gain is the lesser of realized gain or the net boot received.
An individual or entity that is related to the taxpayer, such as a spouse, sibling, or corporation in which the taxpayer holds a significant ownership interest.
Relief / Mortgage Boot
When you assume debt on your replacement property that is less than the debt on your relinquished property, you receive mortgage boot or mortgage relief. Generally speaking, mortgage boot received triggers the recognition of gain and is taxable, unless offset by cash boot added or given up in the exchange.
The property to be sold or disposed of by the exchangor in the tax-deferred, like-kind exchange transaction. The original property is sold by the taxpayer when making an exchange.
The like-kind property to be acquired or received by the exchangor in the tax-deferred, like-kind exchange transaction. The new property is being acquired by the taxpayer when making an exchange.
Reverse / Improvement Exchange
The Exchange Accommodation Taxpayer (EAT) can make improvements to the replacement property before transferring it to the taxpayer as part of a Reverse Exchange.
Type of exchange in which the Replacement Property is purchased before the sale of the Relinquished Property. A tax-deferred, like-kind exchange transaction whereby the replacement property is acquired first, and the disposition of the relinquished property occurs at a later date.
A legal provision to reduce or eliminate liability as long as good faith is demonstrated to comply with laws and regulations. The use of a QI is a safe harbor established by the Treasury Regulations. If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds.
Same Taxpayer Rule
Refers to the requirement that the taxpayer who sells the relinquished property must be the same taxpayer who acquires the replacement property in a 1031 exchange.
Section 1031 Of The Internal Revenue Code
The section of the tax code that outlines the rules for a 1031 exchange.
Seller Carry-Back Financing
When the buyer of a property gives the seller of the property a note, secured by a deed of trust or mortgage. In a Section 1031 Exchange, seller carry-back financing is treated as boot, unless it is sold at a discount on the secondary market or assigned to the seller as a down payment on the replacement property.
A tax-deferred, like-kind exchange transaction whereby the disposition of the relinquished property and the acquisition of the replacement property close or transfer at the same time. A Simultaneous Exchange is also referred to as a Concurrent 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.
Under the “Starker” ruling, you may have theoretically sold your farm, but you cannot be taxed on your “theoretical” profits if you identify a replacement property within 45 days and if you fail to complete the starker exchange within 180 days.
An increase in the cost basis of an asset, which reduces the amount of capital gains tax owed when the asset is sold.
Straight-line Depreciation Method
A depreciation method spreads the cost or other basis of property evenly over its estimated useful life.
Refers to the requirement that the taxpayer must make improvements to the replacement property that exceed a certain threshold in order for the property to qualify for a 1031 exchange.
Tangible Personal Property
Property is other than real estate that physically exists. Aircraft, business equipment, and vehicles are examples of tangible personal property. Assets such as trademarks, patents, and franchises only represent value and are therefore intangible property.
The amount used to determine the taxable gain or loss on the sale of an asset, such as real estate.
Tax Deferred Exchange
An exchange of property that allows the taxpayer to defer paying capital gains tax.
A transfer of property that is subject to tax, such as a sale of personal property.
An individual or entity that is subject to taxation.
Insurance that protects the lender or buyer against any defects in the title of the property.
The entity that owns/holds title to the property. In an IRC Section 1031 Exchange, the titleholder of the relinquished property must generally be the same as the titleholder of the replacement property. If a taxpayer dies prior to the acquisition of the replacement property, his or her estate may complete the exchange. When the acquisition and disposition entities bear the same taxpayer-identification numbers, such as disregarded entities (single-member LLCs and Revocable Living Trusts), the exchange usually qualifies.
A third-party intermediary that holds the proceeds from the sale of a relinquished property until a replacement property is acquired.
UBIT (Unrelated Business Income Tax)
A tax on the income generated from an unrelated business activity conducted by a tax-exempt organization, such as a charity, using a 1031 exchange.
UP-REIT (Umbrella Partnership Real Estate Investment Trust)
A publicly traded partnership that owns and operates real estate, using a 1031 exchange to acquire properties.
Property used for personal use, such as a second home, that is not held for investment or business purposes and does not qualify for a 1031 exchange.
A mortgage that includes the outstanding balance of an existing mortgage, in addition to the new loan amount.
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