1031 Tax Exchange Examples
The below diagram illustrates the benefits of exchanging versus selling
$350,000 – 25,000– 91,000
Sale Price Closing Costs Gain Tax Available for Reinvestment
Sale Price Closing Costs Gain Tax Available for Reinvestment
Misconceptions About Tax Deferred Exchanges
Before we continue by identifying the various types of exchange strategies and their associated rules, 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. Often 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 exchanges.
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 the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words, apartments for apartments, hotels for hotel, 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
Assuming a delayed 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 Exchangor), the Buyer, and the Intermediary (also called the facilitator)
Upon Phase Two (the purchase of your replacement property), they are:
the Taxpayer (also called the Exchangor), the Seller, and the Intermediary (also called the facilitator)
Basic Exchange Rules
Let us look at a basic concept, which applies to all exchanges. Utilize this concept to fully defer the capital gain taxes realized from the sale of a relinquished property:
1. The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
2. All equity received from the sale of the relinquished property must be used to acquire the replacement property.
To the extent that either of these rules is abridged, a tax liability will accrue to the Exchangor. If the replacement property purchase price is less, there will be tax. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the exchange will not qualify for these reasons; partial exchanges do in fact qualify for partial tax deferral. It simply means that the amount of any discrepancy will be taxed as boot, or non like-kind property.
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.
Selecting Your Facilitator
There are virtually no state or federal regulations governing the function of facilitators, other than the fiduciary responsibilities that govern the conduct of any entity holding or handling other people’s money. For this reason, care in selecting a facilitator for you or a client’s exchange is an important process of evaluation. Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities. Talk to escrow and closing professionals that handle exchanges and get their opinion. If possible choose a facilitator who is thoroughly familiar with the process, since many times other aspects of the process will bear significantly on your exchange. For instance, the handling of Promissory Notes, bulk transfers or other variations. Ask the facilitator if their firm handles reverse exchanges. If they do not, the company and its personnel may not be adequately experienced. Ask about the security of your funds, and what options you as an Exchangor may have to assure that your funds will be safeguarded. Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and its personnel to complete your exchange promptly, professionally and legally.
Tax Consequences of Exchanging
In order to assess the tax consequences inherent in any exchange transaction, it is first necessary to understand the definition and exchange related meaning of terms such as Cost Basis, Adjusted Basis, Capital Gain, Net Sales Price, Net Purchase Price and Boot.
Cost Basis: This is where all tax related calculations in an exchange begin. Cost Basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $175,000, your Cost Basis is $175,000.
Adjusted Basis: At the time of your exchange it is necessary to determine your current, or adjusted basis. This is accomplished by subtracting any depreciation reported previously, from the total of the original cost basis, plus the value of any improvements.
“Realized Gain” and “Recognized Gain” are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be “boot”. So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non like-kind property in an exchange is taxable. Therefore, boot is taxable.
There are two types of boot, which can occur, in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt, which can arise, between the exchange or relinquished property and the replacement property.
As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you’ll have what is called “overhanging debt” and the difference will be taxable.
Lets assume for example that you are selling your relinquished property for $375,000 and that it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held y your facilitator.
Suppose that you then find a new property also costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of this debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.
Likewise, cash boot reflects the amount of cash or other value received.
New Adjusted Basis: This figure reflects the necessary adjustments to your basis after the replacement property is acquired. Since the amount of deferred gain must be considered, the calculation below will serve as a method for determining the new adjusted basis on the replacement property.