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At Luxe Stone Exchange Services, we work with clients of all sizes, from small startups to large corporations. We also work with individuals seeking personal consulting services.

 A 1031 exchange is a swap of one real estate investment property for another in a specific way that allows for capital gains taxes to be deferred. 

The process of conducting a tax deferred 1031 exchange can be complex, but provided the specific criteria are followed, real estate investors can realize the many benefits and advantages of deferring the payment of capital gains tax. 

Two-Party Simultaneous Exchange: Two property owners agree to swap deeds and ownership interest of their properties. This method is rarely used since it is usually very difficult for exchangers to find fair-market-value properties with matching debt and equity structures. Delays in ownership transfer can also negatively impact the integrity of the exchange and expose exchangers to serious liability.

Delayed Exchange: non-simultaneous or deferred exchanges taking place within 180 days of relinquishment and acquisition of a replacement property.

Build-to-suit/Improvement/Construction Exchange: exchangers can make improvements on a target asset using their equity generated from the exchange but must be completed within a 180-day window. Exchangers can either refurbish or make capital improvements to existing real property or build new from the ground up.

Reverse Exchange: A replacement property is acquired before an existing property is sold.

There are seven recommended steps common to most Section 1031 tax deferred exchange:

BEFORE YOU CLOSE ON THE SALE OF THE RELINQUISHED PROPERTY:

Step 1: Consider retaining the services of a certified public accountant or an attorney with tax deferred exchange experience to assist in planning for an exchange.

Step 2: Engage a Qualified Intermediary, or “QI,” (also called an Accommodator), being sure to name the QI as the principal in the sale of the relinquished property and in the purchase of the replacement property.

Step 3: Sell the relinquished property, making sure to include a cooperation clause requiring the buyer to cooperate with the seller’s 1031 exchange, and instruct the escrow officer or closing agent to order exchange documents from the QI.

AFTER CLOSING THE SALE OF THE RELINQUISHED PROPERTY

Step 4: Escrow closes on the relinquished property, with the closing statement showing the QI as the seller, and sales proceeds from the relinquished property are sent to the QI and placed in a separate segregated trust account.

FAILURE TO SEND SALES PROCEEDS DIRECTLY TO QUALIFIED INTERMEDIARY FROM ESCROW WILL RESULT IN INABILITY TO EXCHANGE.

Step 5: Within 45 calendar days of the close of escrow of the relinquished property the exchanger identifies one or more replacement properties and sends written notice of this to the QI.

Step 6: The exchanger executes a purchase contract with the seller of the replacement property, making sure the cooperation clause is included in the purchase contract, and naming the QI as the buyer of the replacement property.

Step 7: Within 180 calendar days of the close of escrow of the relinquished property, the exchanger instructs the QI to transfer funds to close escrow and sends 1031 exchange-related documents to the escrow company, and the sale closes with the closing statement showing the QI as the buyer on behalf of the exchanger.

• After the replacement property has closed escrow, the QI will send a final accounting statement to the exchanger. The statement will show that funds have come from one escrow directly into another, all without the taxpayer having constructive receipt of the funds.
• Real estate investors should note that although the qualified intermediary is indicated as the seller and buyer on the purchase contracts, the deed and title are always from the taxpayer to the buyer, and from the seller to the taxpayer.

• Seller must never take possession of funds from the relinquished property
• Replacement Property must be like-kind real estate of the same nature or character, but can differ in type, quality, or grade (such as commercial property being replaced with residential rental property, industrial property, or raw land).
• Real estate must be used for investment or business only, not as personal property or not as a primary residence.
• Title of the relinquished property and the replacement property must be owned under the same tax ID number.
• For Non-reverse Exchanges, replacement property (or properties) must be identified within 45 calendar days of closing on the sale of the relinquished property.
• Purchase of the replacement property (or properties) must occur within 180 calendar days of closing on the sale of the relinquished property for Non-Reverse Exchanges.

 1031 exchanges must still be reported to the IRS by the taxpayer even though tax payment is deferred, and no gain or loss is being recognized:

• Form 8824 is used to report like-kind exchanges
• Form 8824 instructions explain in detail how to report a 1031 exchange to the IRS
• Boot received from a difference in value or mortgage amounts between the relinquished property and the replacement property is reported on Form 8949 of Schedule D (Form 1040) or on Form 4797, whichever is applicable to the investor

If depreciation is recaptured, resulting in a recognized gain, it may need to be reported by the investor as ordinary income during the applicable tax year.

Allowable closing expenses for 1031 exchange purposes are: Real estate broker’s commissions, finder or referral fees Owner’s title insurance premiums Closing agent fees (title, escrow or attorney closing fees) Attorney or tax advisor fees related to the sale or the purchase of the property Recording and filing fees, documentary or transfer tax fees Closing expenses which result in a taxable event are: Pro-rated rents Security deposits Utility payments Property taxes and insurance Associations dues Repairs and maintenance costs Insurance premiums Loan acquisition fees: points, appraisals, mortgage insurance, lenders title insurance, inspections and other loan processing fees and costs For more information about allowable closing expenses, see What are Valid 1031 Exchange Selling Expenses? [As Of June 2024]

Identifying a replacement property means having a written purchase contract accepted by the seller of the replacement property. The purchase contract will have a contingency or cooperation clause noting that the property will be acquired through the buyer’s 1031 Exchange. 

•  The definition of a qualifying like-kind property is very broad, for both the sold property and the replacement property: real estate used for investment or business purposes. Personal use property is not eligible.
• Investment real estate (held for either appreciation or for rental) can be exchanged for real property used in a trade or business. Partial interests such as TICs or DSTs, are exchangeable with other types of real property.

•  Raw land
• Shopping center / retail property
• Warehouse
• Residential property used for rental purposes for income
• Apartment building / duplex
• Commercial office building
• Industrial property

•  There are two types of proportional ownership structures recognized by the IRS for use in 1031 tax deferred exchanges: Delaware Statutory Trust (DST) and Tenancy in Common (TIC) 

A like-kind replacement property is identified if it is designated as replacement property in a written document signed by the exchanging party and received by the QI before the end of the 45-day identification period. Every QI uses their own form of documentation. Please consult with your QI to determine the exact procedure they require.  

• Three-property rule: allows exchangers to identify up to three potential replacement properties for the property being relinquished, regardless of their market value. Only one of the three replacements must be purchased.
• 200% rule: allows exchangers to identify an unlimited number of replacement properties provided that the combined total value of these properties does not exceed 200% of the value of the property being relinquished.
• 95% rule: allows exchangers to identify an unlimited number of replacement properties for the property being relinquished. But unlike the 200% rule that puts a limit on the total value of the identified replacement properties, the 95% rule requires the investor to actually purchase 95% of the aggregate value of the replacement properties identified.

• A Qualified intermediary (QI), sometimes referred to as an “Accommodator,” is an independent third party and not a related to a subject party. In a 1031 Exchange, a QI is a person or business who enters into a written exchange agreement with a taxpayer to acquire and transfer relinquished (sold) property and acquire replacement property and transfer it to the exchanger.
• A QI in a 1031 tax deferred exchange can incur a large amount of potential liability if they make an error. The IRS will disallow a tax deferred exchange if 1031 documents are improperly prepared, creating a capital gains tax liability of tens or even hundreds of thousands of dollars for the exchanger.

Under Internal Revenue Code Section 1031 the Internal Revenue Service defines related parties as:

• Family members including full and half siblings, spouses, ancestors, and direct lineal descendants
• A corporate entity which has more than 50% of its stock owned by a family member
• A grantor and a fiduciary of a common trust
• A fiduciary and a beneficiary of a common trust
• Other corporate entities such as IRC Section 501 organizations, executors, and beneficiaries of a common estate

A Qualified Intermediary in 1031 tax deferred exchanges serves three main functions:

1. Prepare documents the IRS requires for the sale of the relinquished property and for the purchase of the replacement property.
2. Hold the sales proceeds from the relinquished property in a trust account and transfer those funds to pay for the replacement property when the transaction is completed, never allowing the exchanger access to the funds.
3. Pay the exchanger any interest earned from the funds being held during the escrow period.

• Exchangers who attempt to act as their own Qualified Intermediary will have their 1031 Tax-Deferred Exchange disqualified by the IRS and be liable for paying capital gains tax on their transaction.
• Even if an exchanger has funds from a relinquished property wire-transferred directly to a title company to hold for the purchase of a replacement property, the IRS will still disallow the tax deferred exchange. Although the exchanger never “touched” the funds, they still exercised control over the funds, thus making them liable for the payment of capital gains tax.

Sellers cannot take possession of sales proceeds between the sale of the property being relinquished and the replacement property being purchased. If they do, they have “touched the money” and created “boot,” voiding their opportunity to defer paying capital gains on the transaction. By law the taxpayer must use the services of a Qualified Intermediary. 

No, according to IRS, “real property in the United States is not like-kind to real property outside the United States.” 

The term boot refers to non-like-kind property received in an exchange. Usually, boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received.

For example, if a property being relinquished has an existing mortgage loan of $750,000 and the mortgage on the replacement property is only $500,000 the investor will have a gain of $250,000. This difference between the old and new mortgage is classified as boot and is subject to payment of capital gains tax.

Other items given or received in a 1031 exchange transaction such as cash, liabilities, intangible goodwill, or personal property that are not like-kind real estate are also considered boot.

Depreciation is a concept to recognize the effects of wear and tear on the property. Depreciation is a non-cash expense that allows real estate investors to reduce the amount of total taxable net income. 

The longer an investor holds a property the more it is depreciated, which also means the amount of depreciation that must be recaptured also increases over time. Real estate investors often use a 1031 exchange as a tool to avoid the increase in taxable income that the recapture of depreciation creates.

Depreciation recapture is always a factor in calculating the value of a property being relinquished through a 1031 exchange. The degree to which depreciation plays a role varies from investor to investor and is a main reason why real estate investors utilize the services of professionals for 1031 exchange transactions.

Owning real estate gives a unique combination of three benefits that many other investments do not offer:

• First, investment real estate provides two cash flow streams: short-term through the monthly net income and long-term through the appreciation of the real property when it is sold.
• Second, tax law allows owners of real estate to reduce their annual cash income from the property by deducting a non-cash depreciation expense. This allows investors with positive net cash flow to reduce the amount of taxable income from their real estate investments.
• Third, Section 1031 tax deferred exchanges (aka 1031 Exchange) allow real estate investors who sell a like-kind property and replace it with another piece of real estate to defer paying the tax on any capital gains resulting from the exchange transaction. In our Luxe Stone 1031 Exchange Guide we illustrate how one investor was able to grow the value of his real estate investment portfolio by nearly 70% by deferring the payment of capital gains tax and reinvesting the sales proceeds in like-kind real estate.

A Delaware Statutory Trust is a real estate ownership structure where multiple investors can each purchase an undivided fractional interest in the holdings (real estate) of the trust. The trust is established by a “DST Sponsor”, who identifies and acquires the real estate. Investors own a beneficial interest in the trust, thus making them “Beneficiaries.

DST investors also have access to owning investment grade commercial real estate. However, because Delaware Statutory Trusts are entities, investors also benefit from several advantages unique to DSTs that are typically not found in other ownership structure:

• DSTs are completely passive investment as all major property decisions are made by a trustee of the trust or asset manager, not by the owners /beneficiaries.
• Financial institutions can make loans to the DST entity directly without each individual investor having to qualify for the loan.

There are numerous advantages to investing in a DST structured property offering.

• The purchase of DST interests is simpler, faster and does not require as many documents as buying sole ownership of a property.
• Capital Gains are deferred, if investment is for a 1031 Exchange
• No daily property management obligations that come with sole ownership
• Ability to create a diversified real estate investment portfolio
• Cash flow distributions
• Annual depreciation/tax deductions
• Appreciation upon sale of the property
• Upon the sale of a DST property, the investor may engage in a 1031 exchange, even if the DST interest was purchased without 1031 exchange proceeds.
• A DST is a pass-through tax entity, which is not subject to federal income tax, nor to the Delaware franchise or income tax.
• Because the DST is the mortgage borrower, the lender does not require individual DST investor guarantees, nor does the lender require investors to submit personal financial information to qualify for the mortgage loan.
• Investors with interest in a DST property are protected from property liabilities held by the DST. As a result, the maximum pre-tax loss (excluding income tax considerations) is equal to the amount invested in the DST.