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Types of Exchanges:
Simultaneous Exchange The relinquished property and the replacement property are transferred concurrently.
Delayed Exchange (Also referred to as Deferred or Starker Exchanges) This is the most common exchange. The replacement property is identified within 45 days and acquired by the end of the exchange period.
Reverse Exchange The replacement property is acquired before disposing of the relinquished property.
Build-To-Suit (Construction) Exchange The relinquished property is sold in a delayed exchange and then the replacement property is acquired after it has been improved with the exchange funds from the relinquished property.
Reverse Build-To-Suit Exchange The Exchangor is allowed to acquire and improve or repair the replacement property prior to transferring the relinquished property.
Categories of Exchanges:
Personal Property Exchange Personal property held for investment or used in trade or business can be exchanged only for property that is similar in use or in quality. Rules can be complex. (cow ≠ bull, tractor ≠ bulldozer, AM Radio Frequency = FM Radio Frequency)
Real Property Exchange All types of real property are generally considered like-kind to other types of real property. (vacant land = office building)
Mixed Use Property Exchange When Exchangors are seeking to exchange property having both real and personal property components, allocation must be made to each category and relinquished personal property must be matched up with like-kind replacement personal property.
4th quarter 1031’s – Note that the required completion date for 1031’s is the lesser of 180 days or the annual due date (usually April 15th) of your Federal tax return. Therefore if your relinquished property sale transaction occurs on or after October 17th and before December 31st your 180-day window for closing on the replacement property shrinks. An easy way around this is to simply file an extension on your tax return due date. Almost without exception you should complete your 1031 transaction before filing your tax return.
453 Exchange – Used in 1031 Exchanges when the seller accepts a carry back note in lieu of cash.
Like Kind Test – Once you’re satisfied that you’ve met the “Qualified Use Test” the second criteria is the “Like Kind Test”. Essentially any kind of real estate is “like kind” to any other real estate. You can sell a single-family rental home and buy vacant land, mineral interests, an apartment building or even water rights with a 1031 or vice versa; the key factor being you must plan on holding the property long term. This like kind rational extends beyond real estate into all asset categories (i.e. you can sell an AM radio station and buy a TV station with a 1031 exchange) as long as you’re not intending to flip the property in the short term.
Portfolio Repositioning – The act of repopulating your investment portfolio to (a) achieve a desired return or (b) position your assets in a more desirable manner. A 1031 exchange can facilitate portfolio repositioning by diversifying (IE selling one property and buying three), downsizing (by consolidating down to one or two properties that are easier to manage) or (c) by shifting categories within an asset class (i.e. selling a single family rental property & buying a multi-family) in anticipation of a greater capital appreciation in that category. A 1031 exchange facilitates these changes by deferring your capital gains taxes.
Property Identification Limits & Rules – There are three rules that limit the number of properties that can be identified. The taxpayer must meet the requirements of at least one of these three rules:
- (a) Three Property Rule – The property exchanger is permitted to indentify up to three replacement properties within the 45-day post-sale replacement property identification deadline. This provides a handy means to diversify into multiple properties with a 1031 as well as a way to have a qualified backup property to exchange into should your replacement property fall through.
- (b) The 200% Rule – Under this rule there’s no limit on the number of replacement properties you identify. But there is a limit on the total fair market value of the properties you identify. They cannot in the aggregate exceed 200% of the fair market value of the property you’re relinquishing. And ultimately you must purchase a property or properties that in the aggregate are equal to or greater than the property you have sold.
- (c) The 95% Rule - An exchanger can identify as many properties as he wants with no limit on either the quantity or value – provided he closes on at least 95% of the properties he identifies. This approach is well suited for transactions involving bulk buying such as purchasing multiple lots in a subdivision from the same seller.
Qualified Intermediary – The “Accommodator” who arranges a 1031 exchange by (a) drafting all legal 1031 documents, (b) hold net proceeds during the exchange & (c) advise all related parties (IE CPA’s, lawyers, realtors) on the 1031 process and its fixed deadlines.
Qualified Use Test – This is a key concept for all 1031 exchanges and applies to both properties; the one being sold or “relinquished” and the one being purchased or the “replacement” property. A 1031 is valid if the intent with the purchased property is to hold it as a rental property (for cash flow), investment (for capital appreciation) or used in a business. 1031’s aren’t valid if the intention is to develop (i.e. convert an apartment bldg into condos) or “flip” a property in the short term.
1031 Exchange – An IRS-approved transaction that allows you to sell a property, defer the payment of capital gains taxes and reinvest 100% of the cash proceeds into the purchase of a new property.
1031 Fiduciary Funds – The cash proceeds generated by the sale of the replacement property and placed into a fiduciary account by the Qualified Intermediary. The “QI” will release funds at the time of, and concurrent with, purchase of the “replacement” property. At no time may the property owner or “Exchanger” take possession or control of these fiduciary funds or the exchange will be disqualified and the exchanger will become liable for capital gains taxes on his relinquished property.
1031 Improvement Exchange – Allows you to relinquish a property and buy a replacement property for a little less and use the left over cash to make improvements to the replacement property. Can also be done on a reverse exchange basis.
1031 Partnership Interest – With partnership and LLC interests and shares of incorporation it is important to identify clearly who is selling the property and who is buying the property. If a partnership is relinquishing a property, identifies a replacement property and plans to stay intact as a partnership for the purchase of the property a 1031 exchange will work. But if the partnership is to be dissolved upon relinquishing a property a 1031 becomes problematic. Partners in a partnership don’t own the partnership’s properties to begin with; they own partnership interests. The partnership as an entity owns the property. Only the person or entity owning the property can do a 1031. One possible solution is for the partnership to restructure its property interests (IE divest a property to the individual partners) prior to the sale of a replacement property.
1031 Reinvestment Requirement - The basic rule is that the replacement property must be equal to or greater than the fair market value of the property being sold in order for a 1031 exchange to work properly. Otherwise you risk voiding the exchange and triggering a tax liability. One exception to this rule is the Improvement Exchange.
1031 Reverse Exchange – Allows you to buy the replacement property first before you sell your “relinquished” property. Reverse exchanges are generally more costly & complicated to implement but a great strategy nonetheless for special situations like short sales & foreclosures. Plus a reverse exchange conveniently sidesteps the standard 45-day identification rule, which can be very stressful.
1031 Short Sale – In a short sale the relinquished property is “upside down” because you’re selling it for an amount less than what’s owed on the property and yet still have a capital gain to address. The 1031 mechanics behind such a transaction – be it a forward or reverse exchange – remains the same with the key exception being no cash is transferred to the Qualified Intermediary because 100% of cash proceeds from the relinquished property sale is used to pay off creditors. Note however you still need a QI to affect a 1031 under these circumstances.
1031 Vacation Property – There are 3 provisions that must all be met in order to qualify for a 1031 exchange; (i) you must have owned the property for at least 24 months, (ii) you must rent it out for at least 2 weeks per year & (iii) you must limit your personal use to the greater of either 14 days or 10% of the total number of days you’ve rented the property out in a calendar year. For example if you’ve rented the property out one year for 200 days you may use it personally in that year for no more than 20 days.
1033 Exchange – Is an involuntary conversion commonly seen in two situations (a) a natural disaster (IE fire, flood, hurricane, mud slide. etc.) in which the property is partially or fully destroyed; normally resulting in an insurance payment to the owner or (b) condemnation situation (i.e. eminent domain situation) in which a government body tells you what your property’s worth and takes it from you for the public good. You don’t need a qualified intermediary for a 1033 exchange but you do nonetheless need to reinvest an amount equal to or greater than the cash proceeds received for the condemned property. 1033 exchanges also give you a considerably longer time frame to reinvest than a 1031 exchange; 2 years for natural disaster situations, 3 years for eminent domain and up to 5 years in certain natural disaster situations with an IRS extension.
Reverse Improvement Exchange – In this transaction you buy the replacement property first and use additional monies to make an improvement to the property. Later with the proceeds from the sale of the relinquished property you repay the monies earlier advanced to make the improvements.
Umbrella Partnership or UP REIT – aka the “1031 / 721 exchange”. You can’t sell a commercial property and reinvest the proceeds directly into a real estate investment trust (“REIT”) with a 1031 exchange. That’s because with a REIT you’re really buying a security – not real estate. But the two-step 1031 / 721 exchange achieves the same outcome by (a) selling your commercial property via a 1031 exchange and investing the proceeds into a fractional interest of a property that has been or will be purchased by a REIT and, (b) once that occurs contribute your fractional interest to the REIT with a 721 exchange. This is a great way to diversify your real estate holdings while maintaining the 1031 tax deferrals and is therefore a favorite for estate planning. But once your sell your REIT holdings you cannot revert back into another 1031 for yet another real estate purchase.
Contact us to learn how we can help you with a 1031 Exchange in NJ. Our New Jersey real estate attorneys are experienced and helpful.