History of Exchanging Tax deferred exchanging in some form has been with us since the 1920s. However, the difficulty associated with completeing an exchange up until the late seventies was related to those issues which arose around having to complete every transaction simultaneously. That s right, up until the case law arising from the Starker decisions every exchange had to be done where all the transfers were completed on the same day. Not an easy task at all. But what happended with the Starker situation was this. The Starker family sold some land to Crown Zellerbach and instead of receiving cash in the sale, they took a credit on the books of the company. Then over the course of a few years, as the Starker family found replacement property they wanted, Crown Zellerbach would buy it and and have it deeded to the Starkers and applied against their credit. Well, you can imagine that the Internal Revenue Service was unimpressed with this entire approach so they questioned it and everything ended up in tax court. But interestingly enough, what arose from the proceedingings was that the delayed exchange concept was upheld. Granted, not all of the Starker transfers were found to be compliant. But enough were so that for the period between the Starker case law rulings and 1984, delayed exchanges could actually be completed legitimately in the circuit which heard the case. Well obviously, if you no longer had to close everything simultaneously, you d do a delyaed exchange as well. So naturally, exchange volume increased. In fact it increased to such an extent, that the Internal Revenue Service codified delayed exchanging in 1984 simply in an effort to get some control around the process. For instance that s where the 180 day time frame and identification rules came from. Since then we ve gotten rules for reverse exchanges which make them easier to easier to complete as well as several Revenue Procedures and other forms of Guidance hat deal many other forms of exchanging. Everything from the programmed exchanging of fleets of cars and trucks to the partial exchange of assets which are govered by different sections of the Code. But that s a little context a little history of tax defrred exchanging. What is a Tax Deferred Exchange? A tax-deferred exchange represents a simple, strategic method for selling one qualifying property and the subsequent acquisition of another qualifying property within a specific time frame. Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a sale. And it is this distinction between exchanging and not simply selling and buying, which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.
Internal Revenue Code, Section 1031 Because exchanging represents an IRS recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction. It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by The Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction. Why Exchange? Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20%-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70%-80% of what it did previously. The below diagram illustrates the benefits of exchanging versus selling SALE EXAMPLE EXCHANGE EXAMPLE $350,000 Sale Price $350,000 Sale Price -25,000 Closing Costs -25,000 Closing Costs $91,000 Fed Capital Gain Tax $0 Capital Gain Tax $234,000 for Reinvestment $325,000 for Reinvestment Types of Exchanges Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives. Simultaneous Exchange Investors have been doing simultaneous exchange s since the 1920 s. In fact, prior to Congress modifying the Internal Revenue Code as to exchanges and formally approving the concept of delayed exchanging, virtually all exchanges were of the simultaneous type. To qualify as a simultaneous
exchange, both the relinquished property and the replacement property must close and record on the same day. Improvement and Construction Exchange In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose that an Exchanger has intended for it. This construction or improvements can be accomplished as part of a structured exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, for instance if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would be equal to the relinquished thereby allowing the transaction to remain tax free. Improvement and construction exchanges can be tricky however. That s because the process does require the use of a concept which we use in reverse exchanges. Namely, a warehousing of the title until such a time as the improvements are done or the 180 days is close. This is because technically you cannot exchange into property you already own. So if you bought the replacement and then did the improvements, the value you added would not count towards the exchange. That is why we use what is called an EAT or exchange accommodation titleholder. Business or Personal Property Exchange Although when it comes to exchanging most people assume the property is always real estate, in actuality, Internal Revenue Code Section 1031 does allow the exchange of many types of property other than real estate. Investors may exchange, for example, rail cars, trucks, ships, art work, classic cars or livestock, among other assets. In fact, business or personal asset exchanges are a very common transaction. Look at the oil and gas space for instance. And while the basic exchange rules are the same, certain complications arise in classifying the non-real estate assets into one of several categories or SIC classes so that they meet the associated like-kind requirements. Plus there is some additional guidance in the form of Rev Procs, or Revenue Procedures. But if you need to do a personal property or business asset exchange you re probably not going to be doing it without some expert advice. Reverse Exchanges The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchanger cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchanger. The Exchange Last strategy is utilized only when the Exchanger requires traditional financing to complete his acquisition of the replacement property. Since few lenders would lend dollars to the Exchanger with the facilitator or Qualified Intermediary (known in this case as an Exchange
Accommodation Titleholder) on title, it is necessary for the facilitator to warehouse or hold the title to the relinquished property. In this approach, the exchange is complete at the moment the Exchanger accepts the title to the new replacement property. However, with the prospect of the exchange being complete, it is necessary to balance equities between relinquished and replacement, prior to closing. In other words, upon closing the replacement, there must be an equal amount of equity in the replacement property as is expected to come out of the later sale of the relinquished property. Then, at the time of the later sale of the relinquished or exchange property, any debt is retired and the Exchanger is repaid any dollars which he advanced for the replacement property acquisition. In an Exchange First scenario, the facilitator, with the aid of a loan from the Exchanger, acquires the replacement property and warehouses or holds the property title until such time as the relinquished property is sold and the exchange can be completed. At this point we need to insert several caveats regarding reverse exchanges. They tend to be more complicated than other exchanges and because they involve the holding of title by a facilitator in the form of an Exchange Accommodation Titleholder, they require extensive planning. Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or intermediary. Delayed or Deferred Exchanges Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange. In a delayed exchange, the relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2. The timing requirements are these: you have a total of 180 days or the due date of your tax return to complete an exchange. That is the exchange period. And, the first 45 days of the 180 is known as the identification period in which you need to identify some candidate or target properties to serve as your replacement. And that s the types of exchanges. Like Kind Any tax deferred exchange completed pursuant to Section 1031 needs to involve like kind properties. So what is the definition of like kind? Well, first, it is important to remember that like kind refers more to the way a property is used rather than the way it looks. For instance, the typical single family detached home can be both a personal residence or an income property, right? Okay, so then the definition for like kind essentially boils down to you needing to use your property in one of two ways. And those two methods which make up like kind are property held for investment, and property held for a productive use in a trade or business. Basically property held for income. So as you are out looking for candidate replacement properties, make sure your use of that new property will fit within one of those two categories. And that is the definition of like kind.
Basic Deferred Exchange Time Constraints There are only a few rules which are critical to making your exchange qualify and one of the most significant is the allowance of time in which you have available to complete a delayed or deferred exchange. So here are the two time sensitive rules you need to remember. Okay, first important time rule. You have a total of 180 days in which to sell your relinquished or exchange property and actually buy and close on your replacement property or properties. That is called the exchange period. Also, if you buy more than one, make sure the last one you close is still within that 180 day window or it won t qualify. Now often you ll hear a qualifier or caveat regarding the 180 day exchange period which can be very important. And that is this: you actually have 180 days or whenever your tax return is due, which comes first. So what does that mean? This. If you close your relinquished or exchange property late in the year, say for instance around Thanksgiving, you won t have a full 180 days between then and you re your tax return is due on April 15 th correct? Okay, so if that is the case for your transaction, in order to get the full 180 days you will be needing to file an extension in order to include your exchange in your return. That s what that tax return qualifier really means. Okay, second important time rule. In addition, after you close your relinquished or exchange property, you ll have 45 days from that closing in which to name candidate or targets properties in which to exchange. So that first 45 days out of the total of 180 is called the exchange period. Also, this is important to remember. You must identify under some basic rules. The only time you don t really have to identify is if all your replacement property is already closed within that 45 day window. That s kind of de facto identification anyway isn t it? There are two rules for identifying and one exception which we cover elsewhere, but let me give you the rule which is used 95% of the time. It is this. The three property rule. And it is this: You can name or identify any three properties of any value. But your identification must be in writing, and it must be transmitted or postmarked within that 45 day period. Now you can use our online identification tool in the Exchanger Portal if you prefer. It simply handles the transmission aspect electronically and the signatures are digital. But it is pretty convenient if you are on vacation, and today is your 45 day and all you have is a smart phone. But those are the basic rules. Equity and Gain Defined Equity and Gain are both important to an exchange, but they are never the same number. Let s take a cursory look at how you determine both equity and gain? First equity represents the hard earned value that is yours in any property you own. So, if you take your gross selling price and subtract your closing expenses or closing costs, and then further subtract the amount of any debt, that remaining number which is left over will be your equity. Now how about capital gain? Well in order to determine gain we need to know what is called your costs basis. And your cost basis is going to be informed by when you bought the property. So when you bought the property you had a purchase price correct? Well that will be the start of your cost basis, which actually changes over time. For instance, if you ve done any improvements to the property that amount should be added. And likewise, if you ve deducted any depreciation while you ve owned the
property that will be subtracted. Therefore, lets determine your cost basis and gain this way: Let s find our final cost basis or adjusted basis. That will be our original purchase price, plus any improvement, and then less any depreciation, that gives us our final adjusted basis. Now let s once again take that net selling price from our sale, deduct our final adjusted basis, and bingo, that s our capital gain. One last thing. Here is a very simple rule that works in exchanges if you want to have a totally tax free transaction. And that is.. do these two things and your exchange should be tax free. Number 1, buy a replacement property that is equal or greater in value than your net selling price, and 2) move all your equity from the old property into the new one. If you do those two things, you ll be golden. Misconceptions about Tax Deferred Exchanges Sometimes we can learn more about a given topic if we deal with some of the misconceptions associated with that topic at the same time. Let s identify four common exchange misconceptions. All exchanges must involve the swapping or trading with other property owners (NO) Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange. Oft times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings. All exchanges must close simultaneously (NO) Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed or deferred exchanges, utilizing the 180 exchange window available between sale and purchase as allowed under Section 1031. Like-kind means purchasing the same type of property which was sold (NO) Although the definition of like-kind has often been misinterpreted to mean that the property being acquired must be utilized in the same form as was the property being exchanged. In other words, apartments for apartments, hotels for hotels, farm for farm, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property, which qualify as like-kind: 1) Property held for investment, and, or 2) Property held for a productive use in a trade or business.
Exchanges must be limited to one exchange and one replacement property (NO) This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations which restrict the amount of properties which can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several are perfectly acceptable strategies. Parties to an Exchange What are the parties to an exchange? Well, assuming a delayed or deferred exchange scenario, there are three parties involved in a typical transaction. Upon Phase One (the sale of your exchange or relinquished property), they are: the Taxpayer (also called the Exchanger), the Buyer or Purchaser, and the Qualified Intermediary (also called the facilitator) Upon Phase Two (the purchase of your replacement property), they are: the Taxpayer (also called the Exchanger), the Seller, and the Qualified Intermediary (also called the facilitator) Fees How are exchange fees determined? Well it used to be that exchange facilitators or intermediaries used to charge a modest fee for the exchange which was actually subsidized by interest income which was accumulated by the exchange funds while they were on deposit. Then a ruling came down which attempted to clarify how interest was earned while exchange funds were on deposit and who actually owed the ordinary income tax on that growth factor. Nowadays, most facilitators simply charge a fee that is representative of the actual cost necessary to accommodate the exchange. And, since it has been awhile since anyone actually earned anything on a deposit, most Exchangers are now content to simply have their funds held within a fully secured vehicle or account which is absolutely safe. And since we are dealing with funds safety. Let s just confirm that whether or not you are earning interest for that short period while your exchange funds are on deposit, the most important thing is that your exchange qualifies and that your funds will be available for your purchase when you need them. And frankly, since there have been circumstances where Exchangers thought their funds were safe, only to find out that they weren t, that is a great reason to deal with a restricted account or Qualified Escrow account, such as the one at Banc of California. Difference between Intermediaries Is there a difference between facilitators? Most definitely. However when you are comparing Qualified Intermediaries or facilitators one from another, make sure you are using an apples to apples comparison. For instance, compare facilitators based upon their overall value proposition. Look at the sum of what they can offer you in terms of expertise and exchange experience, fees, and obviously the security of your funds. And if you are inclined to utilize a non-bank QI or partner, please ensure that
your funds will be fully secured in a qualified escrow account. And further, that you have 24/7 visibility into that account. Using the Exchanger Portal Bank 1031 is unique amongst exchange facilitators because we utilize an exchange management technology platform which includes a portal for our Exchangers visibility and convenience. This way, you can login to the Exchanger Portal from any computer at any time, 24/7, and view your balances, communicate with your Exchange Officer, download one of your exchange documents. You can even make a replacement property identification online using the digital signature capability. Exchange Logistics 101 Let s give you a high level view into the logistics of exchanging and how to complete a qualifying exchange in the most painless way possible: First determine whether you and your property qualify to be exchanged pursuant to Internal Revenue Code 1031 and the associated regulations. Are you holding it for investment or income? Then, prepare to sell your relinquished property by including some language which memorializes your intent to complete an exchange in your listing agreement as well as any purchase and sale agreement. Ascertain what your capital gain is as well as your equity. This will give you an insight into how expensive or how much of a property you need as a replacement in order to defer as much gain as possible. Then secure a Qualified Intermediary or facilitator who can provide the necessary professional exchange assistance and who can ensure your funds, after they arrive from the closing, will be deposited safety. Remember, to avoid constructive receipt issues, it is important to understand that you cannot touch or control those funds during the exchange process. Start looking for replacement properties well before the relinquished property closes. That 45 day identification period moves very quickly. And, once you ve located suitable replacement candidates, identify them appropriately, usually to your facilitator, and make you re the identification has been successfully received. Remember, most exchanges that do fail, fail because of irregularities in identification. So any extra care you exhibit within that effort is time well spent. Line up your replacement property financing if any. And before closing contact your facilitator so they can put together the documentation necessary which will tie any replacement acquisition into the overall exchange. And lastly, fill out that Form 8824 and file it with your regular tax return. Constructive Receipt The issue of constructive receipt is one that continues to concern taxpayers, their accountants and tax advisers alike. Over the years that the public has benefited from tax deferred exchanges, various elements of control have been reviewed by the courts in attempting to determine whether the taxpayer has in fact exercised sufficient control over the proceeds from the disposition of the relinquished property so as to be considered in receipt of such funds and thereby taxed. Clearly if a taxpayer receives the proceeds from the disposition of his relinquished property, the use of terms "exchange" or
"relinquished property" have no meaning since the transaction will be viewed as a sale and the taxpayer taxed accordingly. Where someone other than the taxpayer receives and controls the use of the proceeds from the disposition of the relinquished property, the relationship between that person or entity and the taxpayer is closely scrutinized to determine whether or not it is so closely related to the taxpayer that it can be considered that the taxpayer has constructively received the funds. This is why we have created the processes and procedures we have to avoid constructive receipt issues for the Exchanger, while at the same time providing the maximum available safety of funds in all cases.