1031 EXCHANGE RULES

The 1031 Exchange rules are not written down anywhere.

The rules have grown out of Court interpretations of the Section 1031 Like Kind Exchange statute, and out of IRS Revenue Rulings and Private Letter Rulings.

There is no IRS Publication, only this advisory, which is old and not much help.

This situation has led to promoters and salesmen posing as experts advising unwary taxpayers regarding tax matters, and it will likely lead to a Tax Audit, with taxes, interest, and penalties, and could also result in criminal charges.

1031 EXCHANGE TIMELINE

Section 1031 Exchange timeline refers to the timelines that affect a Section 1031 Like Kind Exchange.

The first timeline is the 180 days in which you must acquire a Replacement Property after selling your Relinquished Property.

See details below.

The second 1031 Exchange timeline is the 45 days in which you must identify to your Qualified Intermediary a list of properties which include the property that you will end up purchasing as your Replacement Property.

Those details are also below.

These are statutory timelines, which means that they are written into the law.

There are additional timelines that have been created as a result of Court rulings, IRS Revenue Rulings, etc.

These 1031 Exchange timelines concern such things as how long you must own property, how soon you can refinance a property before or after doing a Section 1031 Exchange, etc.

These are discussed elsewhere on the site.

180-DAY RULE

When you sell your Relinquished Property, there are two Time Periods that start to run immediately, and you must satisfy both of these in order to qualify for Section 1031 treatment for your Capital Gains.

The 180-day Rule says that within 180 days from the Exchange Date, which is the date on which you sell the Relinquished Property, you must close on the purchase of the Replacement Property.

The Rule is different with a Reverse Exchange and Construction Exchange than it is with a Delayed Exchange, so be sure to look at all three.

45-DAY RULE

The second of the two Time Periods that start to run immediately when you sell your Relinquished Property is the 45-day Rule.

This rule says that within 45-days from the Exchange Date, the date on which you sell your Relinquished Property, you must identify to your Qualified Intermediary the possible properties that you will purchase as a Replacement Property.

See 1031 Exchange Rules for more details about these two time limits.

 ACCELERATED DEPRECIATION

Accelerated depreciation is available for the part of your investment property that is made up of personal property.  This is not separate personal property on which you did a Section 1031 Exchange.  That is no longer allowed under the Tax Cuts And Jobs Act.  This is property that is part of your investment property, but is not categorized as real estate, but is categorized as personal property because it has a shorter depreciation period.

Accelerated depreciation means that you will be able, for example, to deduct each year more than ten percent (10%) of the book value of an asset with a ten-year life, instead of only 10% as you would with straight-line depreciation.

The most popular type of accelerated depreciation is called the Double Declining Balance, referred to as DDB.

With this method, in the first year, you would deduct twenty percent (20%) of the book value of an asset with a ten-year life.

For a $10,000 asset you could deduct $2,000.

It gets tricky in the second year.

The book value of a $10,000 asset has declined to $8,000 at the beginning of the second year.

So, now you can deduct 20% of $8,000 = $1,600.

Third year: 20% of $6,400, etc.

In most cases, accelerated depreciation is only available for the furniture and fixtures in a rental property.

If these items are new, you can also elect to take “bonus depreciation,” which I discuss below.

 ADJUSTED BASIS

Your “basis” in your property is what you paid for it, plus any capital improvements you have made.

Your “adjusted basis” in your property is the basis adjusted for the depreciation that you have taken.  In other words, total costs less the depreciation deduction.

It is also referred to as “depreciated basis.”

There are other situations which might result in an adjusted basis, such as a casualty loss (fire) for which you were reimbursed by insurance.

In this case you subtract the amount of the insurance from your basis, and this is your adjusted basis.

But in most cases, the adjusted basis is the result of depreciation taken.

 ASSIGNMENT OF BENEFITS

When you sign your Sales Contract to Sell your Relinquished Property and you want to qualify for a Section 1031 Like Kind Exchange, it is necessary that you have no control over the sales proceeds.

So, you assign the benefits of the contract to your Qualified Intermediary, who will then deal with the Title Company and accept receipt of your Net Sales Proceeds from the closing.

ASSUMPTION OF DEBT

If you sell your Relinquished Property and instead of having the debt on the property paid off at closing from your sales proceeds, but have the Buyer assume that indebtedness, there are two problems.

The first problem is that the debt assumption is considered “boot” and will be taxable to you, unless you assume an equal amount of debt on the Replacement Property which you buy.  Then you “net the boot” and it cancels out.

The second problem is that your lender will probably not release you from primary responsibility on the loan even if they allow the new owner to assume it, and you could end up having to pay it if, say, the property burned and the new owner had not kept the insurance policy current.

Also, if you assume debt on the Replacement Property, this debt will be secured by a first lien on the Replacement Property in favor of the existing lender.  When you go to your lender to borrow the additional amount you need for the purchase, the lender will probably refuse to make the loan secured by a second lien.

The Dictionary can only take you so far in understanding this.  You must explore the tabs above to get a deeper understanding.

BASIS

The basis in your property is the amount that you paid for the property, plus any capital improvements made to the property.

If you have depreciated the property, then your basis become “depreciated basis.”

This is the amount that you paid for the property, plus any capital improvements made to the property, minus any depreciation allowed (even if you did not claim it on your tax return.)

You can walk through the steps and see exactly how this works at Capital Gains Tax.

BONUS DEPRECIATION

Certain new business property that is entitled to claimed deductions is also eligible to claim an addition deduction for a percentage of the purchase price for the first year that it is placed in service.

This is referred to as bonus depreciation.

It is covered by Section 179 of the Internal Revenue Code (IRC), and is also referred to as Section 179 deduction or depreciation.

There are additional sections of the IRC that provide for other types of bonus depreciation, and they are too many to cover here.

BOOT

Boot is anything that you receive for the sale of your Relinquished Property that is not “like kind” property.

It could be cash, or debt assumption, or a promissory note, or a motor home.

It could also be proceeds from a refinancing of the property that you did in anticipation of the exchange without an independent business purpose.

You can read all about the dangers of that at Refinance.

BUY FIRST

In a Reverse Exchange, the Exchangor wants to buy his Replacement Property immediately, before he will have time to sell his Relinquished Property and do a normal Delayed Exchange.

Since he cannot own both properties at the same time, he must use an Exchange Accommodation Titleholder (EAT) to hold title to one of them temporarily.

He has two routes he can go, either “Buy First” or “Sell First.”

If he chooses Buy First, his EAT will acquire title to the Replacement Property and hold it until the Exchangor has sold his Relinquished Property, and then transfer the Replacement Property to him.

Read below about “Sell First.”

BUYER

This is the person who buys the Relinquished Property from the Exchangor.

He could be anyone.

He has no control over whether the Exchangor will be able to qualify for a Section 1031 Like Kind Exchange.

Provided he is not a Related Person, it does not matter what the Buyer does with the property that he buys from the Exchangor.

All he has to do it bring the money.

CAPITAL GAINS TAX

The IRS considers everything that you own to be a Capital Asset, and when you sell a capital asset, you will either have a profit or a loss.

A profit is called a Capital Gain, and it is classified as Income, and there will be a tax assessed.

This is called a Capital Gains Tax.

If you have a loss, you will incur a Capital Gains Loss.  This loss might be used to reduce your other income under some cases.

The way your profit or loss is computed is by taking your sales price and subtracting your basis in the property.

Your basis is what you paid for the property, plus any capital improvements, and minus your allowed depreciation.  This basis is also called your Depreciated Basis.

CAPITAL GAINS TAX RATE

The capital gains tax rate is the rate you will pay for the tax on your capital gains when you sell your investment property.

The is a 0% tax rate, 15% tax rate, and a 20% tax rate.

The rate that applies to you will depend on the amount of your other taxable income for the tax year.

I have an Appendix in my book that explains this.

CAPITAL IMPROVEMENTS

When you have a capital asset, income-producing or not, you will sometimes make improvements to it, such as adding a garage to a Duplex that you are renting out.

This garage is a Capital Improvement.

It must be placed on your Depreciation Schedule and an allowed amount is deducted from your taxable income from the asset each year.

If the property is producing no income from which the Depreciation Allowance can be deducted, the amount spent on the Capital Improvement is added to your basis in the property, and when you sell the property, it is deducted from the sales proceeds in order to determine your Capital Gains.

CONSTRUCTION EXCHANGE

A Construction Exchange is a Section 1031 Like Kind Exchange.

It is just one of the four types.

The others are a Simultaneous Exchange, Delayed Exchange, and Reverse Exchange.

A Construction Exchange is also referred to as a Build To Suit Exchange, and as an Improvement Exchange.

A Construction Exchange is used by someone who wants to buy property and rehab it as his Replacement Property.

But if he buys it, the Section 1031 Exchange is over at that point, before he can do the rehab.

So, the process is that his Qualified Intermediary sets up an LLC called an Exchange Accommodation Titleholder (EAT) to purchase the property and lease it to him and he does the work and then buys the property.

Look at the Reverse Exchange tab above for more information.

CONSTRUCTION IS COMPLETE

This is a phrase instead of a word, but still needs to be in the Dictionary.

“Construction is complete” is a term used in a Construction Exchange.

A Construction Exchange is where you want to buy a property and do construction improvements or buy a piece of real estate and build a structure on it, but you want it to be your Replacement Property in a Section 1031 Exchange.

But if you sell your current property and then buy this property or this piece of real estate, the Exchange is over at that point.

So you will have your Qualified Intermediary set up an entity called an Exchange Accomodation Titleholder (EAT) to buy the property and lease it to you so that you can do the rehab or construction, and when you’ve finished, the EAT will sell the property to you, after you have sold your Relinquished Property.

You will have 180 days to complete the job, and if you do, at the time of closing, the “construction is complete.”

But even if you don’t get the work done on time, you can still finish the Section 1031 Exchange and defer the capital gains tax.

See the next definition.

CONSTRUCTION IS NOT COMPLETE

See the previous definition for background.

Now, if you did not get all of the work done by the end of the 180 day period, you can close on the Section 1031 Exchange, but with some computation.

Please click on the Construction Exchange tab above and read about the specific steps involved and how the numbers will be determined.

DEALER PROPERTY

This is one of the least-understood concepts in the world of Real Estate Investing.

A complete explanation is beyond the scope of this Dictionary, but I do have a comprehensive discussion that I know you will like at Dealer Property.

DEFERRED TAX

Deferred Tax just means that, while you do have a tax liability, it is tentative, and the payment is being put off until the occurrence of some future event.

When that event occurs, you will pay the taxes, unless there is some intervening event which changes the picture.

This is the basis of the strategy used in a Section 1031 Like Kind Exchange.

You sell property and defer payment of the capital gains taxes by purchasing a replacement property.

Then you do the same with that property, and so on.

Taxes are deferred each time.

Then you die.  Your basis in the property is “stepped-up” (increased) to the current fair market value when your children inherit it.

Your children sell the property immediately.

They have no capital gains because they sold the property for the same amount as its value.

Therefore, they do not have to pay the taxes that you have been deferring for your lifetime (or the Depreciation Recapture).

DELAYED EXCHANGE

A Delayed Exchange is the most basic of the three types of Section 1031 Like Kind Exchanges.

You sell your current investment property and you have 45 days from the date of sale to make a list of the possible properties you will purchase as a replacement property.

Then you have 180 days from the date of sale to close on the replacement property.

DEPRECIATION

A full explanation of Depreciation is beyond the scope of this Dictionary, but the basic concept is not.

When you purchase an asset to be used in your income-producing business, you are entitled to a “depreciation allowance” each year to deduct from that income.

If your asset is a rental Duplex, can claim depreciation for 27.5 years.

That means that if you paid $300,000 for it and assigned $25,000 to the value of the land, you can depreciate the $275,000 for the building.

So, for 27.5 years, you can deduct $10,000 each year from the income it produces.

DEPRECIATION RECAPTURE

Now the government wants it back.

When you keep the rent house for five years, claiming a total of $50,000 in depreciation, and then sell the Duplex for $375,000 you will have a capital gains of more than $75,000, the difference between what you paid for it and what you sold it for.

You have depreciated the Basis in the property down to $250,000 so your capital gains will be $125,000.

But $50,000 of that will be because of the depreciation you claimed that reduced the Basis, so now the IRS will tax you 25% on the first $50,000 of your capital gains, and call it “depreciation recapture.”

DISREGARDED ENTITY

If you set up a legal entity, such as a Limited Liability Company, and you do not want that entity to be treated by the IRS for tax purposes as a separate entity from yourself, you can file a form electing to have the entity disregarded for tax purposes.

There are rules for qualifying to make this election.

It does not affect any other legal aspects of the existence of the entity, such as any limits against personal liability that it might afford, it is just an agreement between you and the IRS that the entity will not be taxed separately, it will be “disregarded” for tax purposes.

There are some situations in which you must file the election to be a disregarded entity, and there are some situations in which the IRS will disregard it automatically unless you file an election to opt out of that treatment.

EAT

EAT stand for Exchange Accommodation Titleholder.

It is a legal entity that buys the property that you will rehab, and holds it for you until you sell your current property and finish the rehab on this property, so that you can defer the capital gains tax with a Section 1031 Like Kind Exchange.

You can read about the EAT in the Construction Exchange above.

ESCROW ACCOUNT

An escrow account is an account, usually a bank account, held by one entity which contains funds that are the property of another entity.

A bank will have an escrow account in which it puts part of your loan payment each month and uses the money to pay the property taxes at the end of the year, and then starts accruing funds again.

In a Section 1031 Exchange, when you sell your Relinquished Property, the funds are sent to your Qualified Intermediary to be held in an escrow account until you are ready to purchase your Replacement Property.

This is an area of major concern to real estate investors, and I cover the two types of accounts here, as Qualified Escrow Account and Qualified Trust Account.

EXCHANGE DATE

This is the date on which the Exchangor transfers the Relinquished Property to the Buyer is a Delayed Exchange.

In a Reverse Exchange, it is the date on which the EAT acquires the Replacement Property.

In a Construction Exchange, it is also the date on which the EAT acquires the property that will become the Replacement Property.

The Exchange Date is critical because it is the date on which the 45-day Time Period for identifying the attendant piece of propety begins to run.

It is also the date on which the 180-day Time Period for closing on the second half of the Exchange starts to run.

EXCHANGOR

The Exchangor is the person selling the Relinquished Property and buying the Replacement Property in a Section 1031 Exchange.

The Exchangor can be an individual, a corporation, a partnership, an LLC, or a Trust.

Look elsewhere in the Dictionary for definitions of these entities.

FORM 8824

This is the form that you use to report your Section 1031 Like Kind Exchange to the IRS.

It is a very difficult form to complete and I have a complete explanation of what is involved at Form 8824.

HOLDING PERIOD

There is no “statutory holding period” for either your Relinquished Property or your Replacement Property.

But that does not mean that there is not a required holding period for the two properties.

For your Relinquished Property, you must have held it for at least a year and a day in order for the gain on the sale to qualify as Long Term Capital Gains.

Section 1031 is about deferring taxes on Long Term Capital Gains.

For your Replacement Property, the requirement is that it is “to be held for productive use in a trade or business or for investment.”

The IRS has expressed their position that the property must be held for at least a year, and preferably more, in order to show that it is being held for productive use in a trade or business or for investment.

So, there are holding periods for both Relinquished Property and Replacement Properties.

HUD-1

“HUD” stands for Housing and Urban Development, the government agency.

HUD-1 is a form that is used for all real estate closings in the United States, regardless of the state where they take place.

It is identical (almost) everywhere.

When you buy or sell real estate and it involves a title insurance policy, a lender, etc., you will have a HUD-1.

It is also referred to as a Settlement Statement.

IMPROVEMENT EXCHANGE

And Improvement Exchange is another term for a Construction Exchange, or a Build-to-Suit Exchange, with the “Exchange” being a Section 1031 Like Kind Exchange.

A full explanation of all there can be found at Construction Exchange.

INTENT

“Intent” is the most misunderstood concept in Real Estate Investing.

You need to look at this.

A full explanation of the situation is at Intent.

INVESTMENT PROPERTY

The term “investment property” is important because it says what the property is, but also what the property is not.

For the property you are selling, your Relinquished Property, it must be property that is being “held for productive use in a trade or business or for investment” in order to qualify for a Section 1031 Like Kind Exchange.

It cannot be property that you have bought or developed in order to sell it to customers.

Replacement Property must be property that is “to be held for productive use in a trade or business or for investment.”

That means that you will be renting it out or, if it is raw land, just holding it and waiting for it to go up in value.

You cannot buy Replacement Property and then just sell it for a profit.

But what you must avoid is having either property be classified as “dealer property” and therefore be disqualified from doing a Section 1031 Exchange.

This is critical information and you need to read about it at Dealer Property.

LONG TERM CAPITAL GAINS

Long Term Capital Gains refers to the category of the tax bracket you are in when you sell a capital asset and have a profit.

If you have held the asset, and we are talking about investment income property here, for at least one year and one day, then you holding period is long term, and the tax that you pay on your profit (capital gains) is Long Term Capital Gains tax.

If you have held the capital asset for less than one year and one day, then the holding period is Short Term.

There is also a tax rate for Short Term Capital Gains.

LONG TERM CAPITAL GAINS TAX

The Long Term Capital Gains Tax is the tax that you pay when you have sold a capital asset that you held long term and made a profit.

Long term means at least a year and a day.

Profit means that you sold it for more than your adjusted basis.

Profit is the same as Capital Gains.

The amount of tax due on Long Term Capital Gains depends on your tax bracket, that is, the total amount of your other income for the tax year.

LIKE KIND EXCHANGE

Your Replacement Property must be “like kind” to the property you are selling, your Relinquished Property.

This can best be explained with examples, so you need to read the section on 1031 Exchange Rules where I have done that.

NET SALES PROCEEDS

Your net sales proceeds are what you would be given at the closing on the sale of you property if you were not doing a Section 1031 Exchange and purchasing a Replacement Property.

If you are doing a Section 1031, these are funds that must be sent to your Qualified Intermediary so that you will not have control, receipt,  or constructive receipt of them, and that your QI will transfer back to the closing agent to be used in purchasing your Replacement Property.

OWNER FINANCING

Owner financing is when the seller of the property takes a note and deed of trust on the property instead of receiving cash.

The purchaser will make payments to the owner just like they would be making payments to a bank who loaned them the money to purchase the property.

If the payments are not made as provided in the note, the seller can foreclose on the property under the terms of the deed of trust, just like the bank could do.

Owner financing in a Section 1031 Exchange will result in the Exchangor receiving a note instead of cash in exchange for the property, and this will result in taxable boot.

There are ways to avoid the taxes just as though cash were received, and I discuss those techniques elsewhere.

PARTIALLY TAX DEFERRED

A Section 1031 Like Kind Exchange allows you to defer taxes on your capital gains from the sale of your Relinquished Property.

But you can do an exchange in which you receive part of your capital gains proceeds and only defer taxes on the rest of the capital gains.

This is complex, and I have an explanation in 1031 Exchange Rules that includes examples and numbers.  Please go there for the best information.

PERSONAL PROPERTY

A Section 1031 Exchange can involve two types of property, real property and personal property.

The real property must be exchanged for like kind real property, and the personal property must be exchanged for like kind personal property.

Personal property is considered anything that is not real property.

This will include items like the furniture in a Duplex, or washing machines in the laundry room of any apartment building.

Almost any real property will be considered like kind to other real property if both are used for the same purpose, but personal property is seldom like kind to the personal property that you are purchasing, and this can be a problem.

But the IRS will allow you to lump the real property and the personal property together under some circumstances, and you treat it all as real property and still qualify for the Section 1031 Exchange.

POC

This is an abbreviation that you will see on your HUD-1 Settlement Statement at closing.

It stands for “Paid Outside Closing.”

It means that there was an item that is part of the transaction that was not paid with the proceeds of the sale, but that one of the parties paid directly to the vendor.

You should notice this because you might need the dollar amount of the POC in order to compute your capital gains, or your basis, or to complete your Form 8824 reporting the transaction to the IRS.

PRIMARY RESIDENCE

Your primary residence is where you usually live.

The IRS has specific language for you to look at depending on what situation you are dealing with regarding the definition of a primary residence.

For owners of property, your property will be either your primary residence, a second home, or investment property.

Your primary residence does not qualify for Section 1031 Like Kind Exchange.

Section 121 of the Internal Revenue Code provide an exemption from taxation for your profit when you sell your primary residence if you have lived it as your primary residence for at least two of the previous five years.

The exemption from capital gains tax is $250,000 for a single person, and $500,000 for a married couple, filing jointly.

PROPERTY DESCRIPTION

There are two instances when an accurate property description is very important, and an inaccurate one can disqualify your Section 1031 Exchange.

First, when you sell your Relinquished Property, the Exchange Date, within 45 days you must identify at least three potential properties that will be purchased as a Replacement Property.

You then have 180 days from the Exchange Date to close on your Replacement Property.

In an audit, the IRS can challenge you if you put down some vague descriptions that would allow you to choose from a larger list of properties.

You must be specific.

The second instance is when you are doing a Construction Exchange, and you are identifying a Replacement Property that has not even been built yet, so cannot be described except as to what you plan for it to be.

There is a small amount of leeway here, but be as close to your building plans as you can.

PURCHASE PRICE

This is not the price of the new Replacement Property, this is the original price paid by the Exchangor for the property that is not becoming the Relinquished Property.

It is necessary to start with this price before identifying any of the other prices, because this price determines the Basis in the Relinquished Property, and that Basis is the beginning of all of the other calculations, such as the determination of Capital Gains, net sales proceeds, etc.

QEAA

QEAA stands for Qualified Exchange Accommodation Agreement.

It is an agreement signed by you and your Exchange Accommodation Titleholder (EAT) when you have an independent third party entity taking title to a property that you will then be acquiring from it.

You should read Reverse Exchange and Construction Exchange to see how this works.

QUALIFIED ESCROW ACCOUNT

In a Section 1031 Like Kind Exchange you will do an Assignment of Benefits of your sales contract on your Relinquished Property to your Qualified Intermediary, and your QI will receive your net sales proceeds from the first closing.

Your QI will hold your funds in a financial account of some type.

You should make sure that the account is held in a bank.

You should make sure that the funds are not comingled with the funds of other parties.

You should make sure that the funds are held in a separate account in the name of the QI with the additional “in trust for” or “as trustee for” and your name and TIN on the “memo” post on the account.

If the QI maintains a master account with sub-accounts, make sure that your sub-account is identified with your name and TIN.

Specify that the account must be a Qaulified Escrow Account, and the QI can only withdraw the funds with your consent.

You should have a separate written agreement signed by you and your QI called a “Master Qualified Escrow Account Agreement.”

Read it carefully with an eye toward what happens if your QI goes bankrupt, goes South, or the depository institution doesn’t open up in the morning.

QUALIFIED TRUST ACCOUNT

In a Section 1031 Like Kind Exchange you will do an Assignment of Benefits of your sales contract on your Relinquished Property to your Qualified Intermediary, and your QI will receive your net sales proceeds from the first closing.

Your QI will hold your funds in a financial account of some type.

You should make sure that the account is held in a bank.

You should make sure that the funds are not comingled with the funds of other parties.

You should make sure that the funds are held in a separate account in the name of the QI with the additional “in trust for” or “as trustee for” and your name and TIN on the “memo” post on the account.

If the QI maintains a master account, with sub-accounts, make sure that your sub-account is identified with your name and TIN.

Specify that the account must be a Qualified Trust Account, and the QI can only withdraw the funds with your consent.

You should have a separate written agreement called “Agreement For Qualified Trust Account” signed by you and your QI.

Read it very carefully, with an eye toward what will happen if your QI goes bankrupt, goes South, or the depository institution doesn’t open up in the morning.

QUALIFIED INTERMEDIARY

This is the independent third party that will stand between the Exchangor and all of the parties to the transaction: the Buyer, Seller, Title Company, Real Estate Agent, Contractor, Attorney, Bank, etc.

The purpose of the Qualified Intermediary is to handle the money so that the Exchangor will never touch it or have any control over it, which would disqualify the Section 1031 Like Kind Exchange.

The Qualified Intermediary is paid by the Exchangor to make sure that everything is done in accordance with the Exchange rules and provide documentation for the IRS.

REFINANCE

A taxpayer who wants to take equity out of his property before selling it or take equity out of the property he acquires as a Replacement Property will attempt to refinance the property and avoid the tax on taking part of the net sales proceeds from the sale at closing.

Both pre-Exchange refinance and post-Exchange refinance will lead to the IRS declaring the loan proceeds to be taxable as “boot” because the refinance is part of a step-transaction, and is the same as a distribution of part of the net sales proceeds.

However, refinancing is allowed if done a sufficient amount of time before or after the exchange, is not done “in anticipation of an exchange,” and is done in the normal course of business.

RELATED PERSONS

If you sell your Relinquished Property to a Related Person, or buy your Replacement Property from a Related Person, special rules come into play.

First, a definition: a Related Person means your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.

It also includes a corporation or similar business entity in which you own more than 50% of the stock.

This percentage includes your spouse’s ownership.

It also includes a Partnership and a Limitel Liability Company in which you and your spouse own an interest of more than 50%.

It also includes trusts and estates, with complex issues.

Related Persons can do a direct swap of properties, and that transaction will qualify as a Section 1031 Exchange for one or both of them, but each of them must then hold onto their acquired property for a period that is more than two years after the date of the last transfer which was part of the Exchange.

If either person violates this requirement, the 1031 Exchange is invalidated, with taxes and interest and penalties assessed, for both of them.

Each person who qualified the transaction as a 1031 Exchange must continue to file Form 8824 for two years following the year of the Exchange.

Also, in addition to a direct swap, the Exchangor can sell the Relinquished Property to a Related Person.

But the Related Person is required to hold the property for the two-year period described above, and failing to do so will invalidate the Section 1031 Exchange for the Exchangor.

And the Exchangor is held to the same requirements of Form 8824 described above, except that it might turn into three years, because the period will start to run from the date he acquires the Replacement Property, which could be as long as 180 days after the first transaction.

The only exception to the two-year holding period requirement is in the event of death or other involuntary conversion.

But the real danger is in buying a Replacement Property from a Related Person.  It is not absolutely prohibited, but it guarantees that the IRS will look closely at the transaction.

There is no single “rule” that we can look at to see the IRS position on this, but there are a series of court decisions that make up the position of the IRS.

But if there were a rule, it would say that the IRS just doesn’t like it when one Related Person ends up with the Section 1031 property, and another Related Person ends up with the cash.

RELINQUISHED PROPERTY

This is the property that the Exchangor wants to sell without paying Capital Gains Tax on the profit by using a Section 1031 Like Kind Exchange.

It can be either business property or investment property, or both.

It can be either real property or personal property, or both.

Real property must always be exchanged for like kind real property, and personal property must always be exchange for like kind personal property.

The property must have been held for at least one year and a day.

It must be property held for productive use in a trade or business or for investment.

REPLACEMENT PROPERTY

This is the like kind property that the Exchangor intends to purchase to replace the Relinquished Property in order to qualify for a Section 1031 Like Kind Exchange and defer the taxes on the Capital Gains.

It can be either business property or investment property, or both.

It can be either real property or personal property, or both.

But you must exchange exchange real property for real property, and personal property for personal property.

You cannot exchange real property for personal property, nor vice versa.

It must be property of the type that can be held for investment or for business purposed by the Exchangor.

It does not matter what the previous use of the property was.

The Replacement Property can be a single property, or it can be multiple properties.

And the Exchangor must take title to the Replacement Property in the same name in which the Relinquished Property was held.

REVERSE EXCHANGE

A Reverse Exchange is when you buy your Replacement Property before you sell your Relinquished Property.

It is permitted, but with stipulations and rules.

Read the entire process at Reverse Exchange.

SAFE HARBOR

There are a number of rules that you must follow if you are doing a Section 1031 Like Kind Exchange.

You will have to retain proof that you have done so if the IRS ever requests documentation.

However, there are some procedures that you can follow and the IRS will provide you a “Safe Harbor” that your compliance will not be challenged.

There are many Safe Harbors and you will read about them throughout the material here.

SALES PRICE

This is the price for which the Relinquished Property is being sold, and along with the Purchase Price, will determine the Capital Gains, and will probably be a major factor in you consideration of whether to even do a Section 1031 Like Kind Exchange.

SECTION 121 EXCLUSION

The Section 121 exclusion is the exclusion from capital gains taxation that is contained in Section 121 of the Internal Revenue Code.

Section 121 provides an exclusion from taxation on the profit if you have lived in your home as your primary residence for at least two of the prior five years.

The amount of the exclusion is $250,000 for a single person, and $500,000 for a married couple filing jointly.

If you move out of your primary residence and rent it out for three years and then sell it, you still qualify for exclusion of taxation on all of the capital gains, but you must pay taxes on the amount of depreciation that you claimed while it was being treated as an income property.  This is called Depreciation Recapture.

SECTION 1031

Internal Revenue Code Section 1001(c) requires that the entire amount of the gain or loss on the sale or exchange of property shall be recognized.

Section 1031(a), however, provides for the nonrecognition of gain or loss when property held for productive use in a trade or business or for investment is exchanged solely for like-kind property that is to be held for productive use in a trade or business or for investment.

SECTION 1250 PROPERTY

Section 1250 property is the property that you own and use as investment property.

It is described in Section 1250 of the Internal Revenue Code.

It can only be depreciated using the straight-line method, with equal amounts claimed for depreciation each year.

If the Section 1250 property is the type classified as Residential Real Estate the period of depreciation is 27.5 year.

If the Section 1250 property is commercial real estate, the period is 39 years.

SELL FIRST

This is one of your two choices in a Reverse Exchange.

It is explained in the Dictionary item above, called “Buy First.”

Please go there.

SELLER

This is the person who owns the property that the Exchangor wants to purchase as his Replacement Property.

Like the Buyer of the Relinquished Property, and provided he is not a Related Person, he could be anybody as long as he has the appropriate piece of property to buy.

He will have nothing to do with determining whether the Exchangor can qualify for a Section 1031 Like Kind Exchange.

However, he must be told that the transaction he is entering into involves a Section 1031 Like Kind Exchange for the Exchangor, and that he will be required to do certains things in cooperation.

If the Replacement Property is comprised of more than one property, there might be more than one Seller.

SELLER FINANCING

Seller Financing is when the seller of the property receives a debt instrument from the buyer instead of cash.

If Seller Financing is involved in your sale of your Relinquished Property, or in the purchase of your Replacement Property, it seriously impacts the Section 1031 Exchange.

SETTLEMENT STATEMENT

See HUD-1 above.

TAX DEFERRED

This is the same as Deferred Tax, above Dictionary item.

TENANTS IN COMMON

Tenants in common are two or more individuals owning real estate as a tenancy in common.

A tenancy in common is a shared tenancy in which each holder had a distinct, transferrable interest.

If you and your brother own ten acres of land as tenants in common you will each own an interest equal to fifty percent.

The interest is an undivided interest.

That means that you cannot select five acres and claim it.

You own fifty percent of every 1/100 of a square inch of the ten acres.

You each have equal right to the use and possession of the entire ten acres.

Your interest is freely transferable, by deed or by Will.

TIME PERIODS

There are two critical time periods in a Section 1031 Like Kind Exchange.

One is a 45-day period, and the other is a 180-day period.

You can read about both above, the first two items in the Dictionary.

TITLE COMPANY

Real estate transactions are handled differently in different parts of the country.  In some states, an Escrow Company handles everything.

In some states only Attorneys are authorized to handle real estate closings.

And in some states, the State has licensed a Title Company to handle real estate closings and insure title to the property.

TRANSFERRED BASIS

When you sell a Relinquished Property, you will have a basis in it, which you can read about in Basis, above.

That basis will become part of the new Replacement Property.

I have a very good explanation, with numbers, on the Capital Gains Tax page.