FIVE MISCONCEPTIONS OF 1031 EXCHANGES
1. In order to complete a 1031 Tax-deferred Exchange, a taxpayer has to find someone to “swap” a property with. Originally, prior to 1970, taxpayers would exchange property as “you give me your property, I will give you my property”. After 1970 with the “Starker” Exchange and with the use of a third party called an “Accommodator”, properties are exchanged for other property. Most Exchanges are structured like a sale with the use of an Accommodator allowing for a subsequent purchase.
2. A taxpayer seeking to exchange property has to buy the exact same type of property he is selling in order for it to be considered a “like-kind” exchange. As long as both the property to be sold and the property to be purchased are held for productive use in a trade or business, or for investment purposes, taxpayers are free to purchase whatever type of property they want. For example, a taxpayer can sell an apartment building and exchange it for an industrial warehouse. Income producing property such as rental income can be exchanged for non-income producing property. Zoning is not an issue. California conforms to most IRS rules on Exchanging.
3. Taxpayers must complete the 1031 exchange in one completely simultaneous transaction. Simultaneous or concurrent closings are no longer recommended. Klein vs Comm. 66-TCM, 1115 1993 has allowed IRS to disallow concurrent closings. By virtue of a favorable ruling to the taxpayer in the now famous case of Starker v. United States in 1979, taxpayers have the ability to complete an exchange on a delayed basis so long as they purchase replacement property within 180 days of selling their first relinquished property. Other structures, including reverse exchanges and improvement exchanges, afford taxpayers other types of flexibility during the exchange time frame.
4. Taxpayers must use all the proceeds from the sale of their relinquished property to purchase replacement property. In order to have a completely tax-deferred exchange a taxpayer must follow three essential steps: (1) buy replacement property where the value is equal to or greater than the value of the original relinquished property; (2) use all of the original equity realized from the sale to purchase a replacement property; and (3) obtain equal or greater financing on the replacement property as was paid off on the relinquished property at the time of its sale.
However, while those are the rules for a complete deferral, a taxpayer may violate any one of them and complete a partial deferred exchange. For example, a taxpayer who seeks to buy a replacement property of a lesser value, or with less financing, will recognize a capital gains tax on that amount not reinvested in the new property. Simply put, taxpayers can buy replacement properties for a lesser amount and put cash in their pocket, so long as they don’t mind paying some taxes.
5. I don’t need a qualified intermediary. I can simply have my attorney or accountant hold the sale proceeds until the replacement property is purchased. A qualified intermediary is essential to completing a valid delayed exchange. Basically, the IRS disqualifies any person or entity from acting as an intermediary, if that individual has had an existing business relationship with the taxpayer within the past two years.
Although that statement is somewhat broad, some parties who may be considered disqualified parties are the taxpayer’s relatives, attorney, accountant and real estate broker. The IRS provides that neither the taxpayer, nor any disqualified person, or entity, can come into receipt of the exchange funds nor during the exchange, or the exchange will be void. Using a well-established qualified intermediary enables a taxpayer to avoid situations that might void an otherwise valid exchange. It is also a good practice to research the expertise and security of the qualified intermediary.