Do I have to spend all of the proceeds from my relinquished property on replacement property?
No you do not, however you will be taxed on the amount you don’t spend. Unused proceeds are known as “boot” and are taxed on their face value at the capital gains tax rate.
If I don’t spend all of my proceeds, when can I receive the unused amount?
You can receive unused proceeds at anytime after you have acquired each one of the properties identified in your 45 day identification. If you do not acquire all of the properties identified in the 45 day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return, including extensions, or 180 days after the closing of the sale of the relinquished (exchange) property.
Can I take a note on the sale of my relinquished property?
Yes, you can sell your relinquished property using a Note & Trust Deed to be made out to the “Exchanger.” If this is done, the Note is taxable and may not be used to buy replacement property. However if the Note & Trust Deed is made out in the name of the Qualified Intermediary, you have four choices on how to use it to buy replacement property:
- You can use it to acquire replacement property by trading it to the “Seller” for part of the equity in the new property (that is, spend it like it was cash).
- You can instruct the Qualified Intermediary to sell the note on the open market (you can negotiate this sale or have the Intermediary do it) and add the amount realized to the exchange proceeds. This will give you all cash to negotiate your replacement purchase. It is less desirable because of the discount given on the sale of the note.
- A party related to the “Exchanger,” such as a closely held corporation or relative, can either purchase the Note from the Qualified Intermediary, or provide financing so that the Qualified Intermediary receives all cash at closing. You should consult with your tax advisor regarding structuring this type of transaction.
- You can wait until the end of the exchange and receive the note back from the Intermediary. This will result in the note becoming “boot” and it will be taxable. However, you will only have to pay tax on the amount received each year.
What should I know about new construction of replacement property?
There are two ways that new construction is handled in an exchange:
- You contract with a builder to purchase a property which will be completed, and closed, prior to the end of the 180 day exchange period. You can purchase the land prior to construction as one of your replacement properties, or you can purchase the land and building from the builder at the time of closing. This is the least expensive and easiest method for the exchanger.
- You can contract to do what is known as a “Build-out Exchange.” This is where the Exchanger finances all or part of the construction. Through a special agreement with the Qualified Intermediary, the builder draws on the exchange proceeds as certain steps of the construction are completed. This arrangement is much more complicated and risky for the Exchanger, and the Intermediary, and increases the cost of the exchange by $1,500 or more.
In either case, the purchase and sale agreement should have language in it that requires the builder to bear responsibility for the exchanger’s taxes if the exchange fails due to the completion of the construction later than the required 180 day exchange closing period.
When should I open escrow on my replacement property?
The safest way is to wait until after your “relinquished” property has closed. The opening of escrow (or notification to the closing agent) may constitute identification as the escrow agent is listed by the IRS as a person involved in the exchange, and if it is done prior to the closing of the “relinquished” property, it can shorten the entire exchange period to 45 days. It is a dangerous practice and does not speed up the “replacement” property closing. Replacement property is identified if it is designated as replacement property in a written document signed by the exchanger and sent to the Qualified Intermediary prior to the end of the 45 day identification period. We will send you a form to fill in after your relinquished property closes.
Can I combine multiple relinquished properties into one replacement property?
Yes, you can combine multiple relinquished properties into one replacement property. The rule here is that the first relinquished property to close starts the clock running for all the rest. All the relinquished properties to be combined must be closed within 45 days of the first one to close.
The same replacement property is then identified for each relinquished property to be combined.
If the replacement property is a rental, how long does it have to remain a rental before it can be converted into a primary residence?
There are no hard rules here. What the IRS requires is that you show intent to use the replacement property as a rental. Most of the tax attorneys that we talk to feel that if the property shows up as a rental on two or more consecutive tax returns you will have shown intent.
If the replacement property is sold, how are the capital gains taxes calculated?
The capital gains tax is calculated the same as in any other sale, assuming that you have not converted it to residential use, and that you are not going to do another 1031 exchange.
The trick here is to be able to establish the basis on the new property at the time of sale. The basis on the new property is the sum of the basis transferred from the old property, plus the difference between the sale price of the old relinquished property and the new replacement property, minus the deprecation on the new replacement property.
Can you take cash out of a 1031 Exchange?
You cannot take cash out of an exchange without creating a taxable event. However, you may opt to refinance after the exchange is complete.
Can you direct deed when using an intermediary?
Yes, IRS regulations allow the method known as direct deeding from the grantor to the grantee, as in a typical sale transaction. This procedure eliminates payment of additional transfer taxes.
Can I close on my replacement property before I have a buyer for my relinquished property?
Yes. This exchange process is known as a Reverse Exchange. Although the IRS has not adopted regulations specifically for reverse exchanges, they are believed to receive the same benefits as the deferred exchange. Currently, there are proposed regulations and case law setting the guidelines we utilize to structure Reverse Exchanges. To make the exchange work, a third party or an intermediary must take title to one of the properties until you are ready to convey the relinquished property to a buyer.
If I have already signed my agreement of sale, is it too late to initiate the exchange?
No. As long as you have not settled on the property you are selling, a 1031 exchange can still be completed. However, once the closing occurs, it is too late to take advantage of Section 1031.
Do I need to find someone to swap properties with?
No. 1031 exchanges are not really exchanges in the context of a two party barter. Instead, you are going to sell your property to someone totally unrelated to the person from whom you are acquiring your replacement property. The only real difference between a 1031 exchange and a typical sale and purchase transaction is the deferral of capital gains.
How do I report my 1031 exchange to the IRS?
Initially, your 1031 exchange is reported to the IRS on Form 1099S which should indicate that you are effecting a 1031 exchange and will receive property as consideration for the sale of your relinquished property. IRS Form 8824 must be completed as part of your annual federal return. In addition to determining your realized gain, recognized gain, and your new basis, this form will ask the date you sold your relinquished property, and identified and acquired your replacement property. Form 8824 is actually a supporting form for IRS Form 4797.