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ABOUT REAL ESTATE EXCHANGING
By John McCall
A Real estate exchange is simply when a person gives up ownership of
real estate for ownership of other real estate with little or no cash
given or received. It is a transaction that is generated out of the needs
of an individual or individuals that cannot achieve their desired results
through a buy/sell transaction. There are dozens of reasons why people
exchange their properties rather than selling them in the traditional
manner. Some of the most common reasons are to defer capital gains, to
reduce indebtedness, to increase income, to build an estate, to increase
or decrease leverage. Some need capital appreciation rather than current
income. Many just like the excitement of exchanging, feeling that changing
property ownership is an adventure all its own.
The 1031
section of the Internal Revenue Code is that section which recognizes
the tax- deferred exchange. This code allows an individual to make a
profit in real estate and defer the capital gains until a later date. The
section reads: "No gain or loss shall be recognized when property
held for productive use in trade or business or for investment is
exchanged solely for property of a 'like kind' to be held for productive
use in trade or business or for investment."
Property held for investment could be acreage, commercial property,
houses or any other real estate except a personal residence. The deferred
exchange is built around the phrase, "held for investment." For
example: an apartment house can be exchanged for a commercial strip center
since they are both held for investment and as long as there is no cash
boot or mortgage, a pure 1031 tax-deferred exchange can be achieved. When
making a 1031 exchange, the gain is not recognized although it may be
realized. The taxable event will take place when the estate becomes
activated or when the property is sold. Taxes will be on the selling price
at that time, or its value then versus the current basis at the time.
Most people exchange property to defer taxes. The effects are dramatic!
If a property is sold for a net of $100,000 and the current basis is
$20,000, taxes would be paid on an indicated gain of $80,000 or taxes of
$22,400 (based on a tax rate 28%). This would leave $77,600 to re-invest.
Should the same property be exchanged, the owner could re-invest $100,000.
The exchange method, in this case, is obviously more beneficial.
It is not always necessary to take another piece of property for
exchange. The code provides a method to dispose of your property and have
cash available to buy other real estate, while still qualifying for a 1031
transaction. More specifically, for the purpose of 1031, a delayed
exchange is defined as an exchange in which, pursuant to an agreement, the
taxpayer transfers property held for productive use in a trade or business
or for investment (the relinquished property) and subsequently receives
property to be held either for productive use in a trade of business or
for investment (the replacement property).
As a result of the Starker court decision, the 1984 legislative changes
to the IRS Sec. # 1.1031 were to allow a delay between going out of title
to the relinquished property (the property you are selling) and the time
for closing the designated property (the one you are buying). The object
was to enforce collection of revenue within the taxpaying period set by
the closing of the relinquished property. Legislation simply stated that a
replacement property to be received in the exchange must be identified
within 45 days after the date which the property given up is transferred,
and the new replacement property must be received by the earliest of 180
days after the date of transfer, or the taxpayer's tax return for the year
of the transfer (including extensions).
After five years of review, the IRS issued final regulations. Basic
rules are the same for simultaneous exchanges, except this phase of the
new regulations deals with how property is identified and closed within
restricted time periods, how to avoid selection of a most favorable
property beyond a reasonable time, and how the taxpayer can be protected
from receiving the net equity from the relinquished property closing.
Failure to follow the rules of the delayed exchange defeats the delayed
exchange.
Identification Requirements:
1. In addition to identification within 45 days, including the date of
the relinquished property transfer, this period ends midnight of the 45th
day. The exchange period ends midnight the 180th day after and including
the date of relinquished property transfer. Or, the date of taxpayer's due
date for filing his income tax report including extensions), but in no
event longer than 180 days. There are no exceptions to the 180-day rule.
2. If more than one relinquished property is transferred on different
dates, then the earliest date any property was transferred is the starting
date. Any property received before 45 days is considered identified.
Before the 45 days identification it is by written document signed by the
taxpayer and hand delivered, mailed, telecopied, faxed or otherwise sent
before the end of the identification period to either the person obligated
to transfer the replacement property to the taxpayer or any other person
involved in the exchange other than the taxpayer or other person
disqualified (Qualified persons include intermediary, an escrow agent and
title company).
3. The description of the replacement property must be specific (name
of building, address, legal description).
4. Regardless of the number of relinquished properties transferred, the
maximum number of properties that can be identified by one of the
following:
(A) Any three properties regardless of value.
(B) More than three properties if the total value does not exceed twice
the value of the relinquished property (the 200% rule).
Failure to follow the above two rules is the same as no identification,
except for the following:
(C) Any number of properties if at least 95% of their aggregate fair
market value of all identified replacement properties close (95% rule).
(D) Any replacement property received by the taxpayer before the end of
the 45-day rule.
5. In (A) through (C) above, any property identified that has been
revoked by written document can be replaced by a substituted identified
property if this is accomplished before the 45-day deadline.
Receipt of replacement property:
1. The taxpayer must actually receive the replacement property by the
end of the exchange period.
2. The replacement property must be substantially the same property as
identified (for example, the designated un-built building must be
completed). The fact that the improvements are not complete does not
disqualify the designation. However, that uncompleted portion will not
qualify if the completed improvements are not substantially the same as
identified. Any completed production after transfer does not qualify.
It is strongly recommended that you seek the help of an
experienced professional before attempting your first exchange.
You will also find information about real estate exchanging, properties
held for exchange, real estate exchange organizations, and related tools
and sites at the following URLs
http://www.fourmilab.ch/ustax/www/t26-A-1-O-III-1031.html
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