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What Is 1031 Exchange?
What is an IRC Section 1031 Exchange?
It is an exchange of property held for productive use in a trade or business or for investment for other "like kind" property held for productive use in a trade or business or for investment.
Any taxpayer benefits who has recognizable gain in qualifying property on which they will pay capital gains tax. It is strongly suggested that you consult with your tax advisor to determine the actual tax benefit to you.
To begin an exchange it is best to put a "cooperation clause" in the sales agreement. This puts the buyer and the escrow officer on notice that it is the seller's intent to complete an exchange. Ask the escrow officer to send a copy of the sale agreement and the preliminary title report to American Property Exchange, Inc. They will prepare exchange documents to be signed at closing. The exchange fee is usually paid from the proceeds.
The following properties are not eligible for a 1031 Exchange:
- · Primary residences
- · Second homes
- · Personal Vacation Property
- · Property held for resale
- · Inventory
- · Interests in Partnerships
- · Shares in Corporations
- · Collateral
In a 1031 exchange, "like kind" refers to the character of the property rather than its use. Most real property which is held for productive use in a trade or business or for investment will qualify. Real property must be exchanged for other real property.
A good "cooperation clause" will not only provide the required notice to all parties, it will indicate the Seller's/Buyer's rights may be assigned to an accommodator and will require the Buyer's/Seller's cooperation in the facilitation of the exchange.
Suggested Language
Buyer (Seller) hereby acknowledges that it is the intention of Seller (Buyer) to complete an IRC 1031 exchange which will not delay the close of escrow or cause additional expense to Buyer (Seller). Seller's (Buyer's) rights and obligations under this agreement may be assigned to American Property Exchange, Inc. for the purpose of completing such an exchange. Buyer (Seller) agrees to cooperate with Seller (Buyer) and American Property Exchange in a manner necessary to complete the exchange.
Any party not disqualified under the regulations may act as your accommodator. Disqualified parties include relatives and controlled business entities, your realtor, CPA and attorney. You will want to choose a reputable accommodator with experience and financial security.
American Property Exchange, Inc., is backed by one of the nation's most financially secure multi-million dollar holding companies. The expertise of our staff developed through their 100 years of combined service in the real estate industry is your assurance of superior performance.
When the first property sells, American Property Exchange, Inc., is assigned in as seller. The closing documents are signed by the accommodator and approved by the taxpayer. To prevent constructive receipt, the proceeds are delivered to the accommodator and held for the purchase of replacement property.
All proceeds do not have to be reinvested. Escrow may be instructed to disburse a portion of the funds to the taxpayer and the balance to the accommodator. The exchange agreement needs to be amended to allow for this. Disbursement at the close of the sale or unused funds at the close of the exchange will not disqualify the exchange; however, such funds will be considered "boot."
The selling price can include a purchase money note and mortgage. However, it may complicate the exchange. If the note is to be used in the exchange, it must be put into the name of the accommodator. The note must then be assigned to the seller of the replacement property or converted to cash prior to closing on the replacement property. If neither is accomplished, the note will be assigned to the taxpayer who will pay taxes on any recognized gain.
The escrow company acts upon receipt of written instructions from the seller and buyer. To leave the money in escrow, it is necessary to give instructions. This is control of the proceeds and may invalidate the exchange.
After the property closes the exchange company will send you a form for the purpose of identifying your replacement property. This form needs to be returned within 45 days of the date the taxpayer transfers the relinquished property. There are rules which limit identification to three properties or 200% of the fair market value of the relinquished property.
You negotiate the terms of your purchase agreement which is then submitted to escrow. The exchange company is assigned in as buyer and provides the exchange funds to escrow as required for closing. The acquisition of replacement property must be completed within a total of 180 days or by the date your invoice tax return is due, whichever first occurs.
There can be seller financing in the first phase of a real estate exchange; however, it may complicate the exchange. The reason for this is that the Note and Trust Deed or the Contract of Sale will be a form of proceeds along with the cash received from the buyer. All proceeds, regardless of form, must be used to acquire the replacement property in order to defer tax.
Seller financing can be sheltered through an exchange by the paper being received in the name of the exchange company. If the seller of the relinquished property is willing to accept the paper as part of the purchase price, the exchange company will transfer it at closing. If the seller is not willing to accept the paper, it must be converted to cash (sold) and the cash used to acquire the replacement property.
A common trap to avoid is wrap around contracts and inclusive trust deeds. They present the greatest problems for an exchange. In this form of financing, an underlying financing instrument is wrapped and included within the total balance of the new instrument. This complicates the exchange because the disposition of this form of financing is so difficult.
If the paper is not sold and cannot be used to acquire the replacement property the Accommodator must assign it to the exchanger at the conclusion of the exchange. The monies due under the mortgage, trust deed or contract become "boot". The exchanger may elect to report the income from the paper on an installment basis.
What is boot? Property or other consideration not "like kind" in an exchange. Cash is not "like kind"; therefore, cash received by the taxpayer is boot. Any debt the taxpayer is relieved of, that is not replaced, can be "boot". The taxpayer may contribute additional cash to the acquisition of replacement property to offset debt relief; however, debt assumed on the replacement property will not offset cash received.
General Rule: Equal or greater than in Equity and Value = full tax deferred.
Basis for identification of replacement property
Identification period begins on the date of transfer of the Relinquished Property and ends at midnight on the 45th day following the transfer of the Relinquished Property.
Form
Must be a written document, signed by the taxpayer (exchanger) and delivered to any person involved in the exchange.
American Property Exchange, Inc., provides its clients with an identification form following the transfer of the Relinquished Property. This form needs to be returned to American Property Exchange via delivery, mail or fax.
Content
Replacement properties must be listed by legal description, street address and city/state, or distinguishable name.
The regulations require the replacement property be unambiguously described!
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