1031 Tax Exchange

So you’ve begun a 1031 exchange and have sold your relinquished property. A few weeks ago, you identified a property that you believed to be your best bet for a replacement. You formally identified the property (including an “unambiguous description”) in a written document that was signed and delivered to your qualified intermediary. This morning, however, you stumbled on another property that you’d very much like to buy – more so than the one you have already identified. Now what?

If your 45-day identification period is finished, you’re pretty much out of luck, and you cannot change your identified property. If, however, your 45-day identification period is still active, you can legally change your identified property. To revoke your identification of a property that you no longer wish to purchase, you must write a formal letter stating the revocation. Depending on the status of your transaction, you may also need to include a formal rescission of any purchase and sale agreements. For 1031 exchangers, then, there is some welcome flexibility in the identification process. As long as you are within the bounds of your 45-day identification period, you will be able to change your mind about your identified property and stay within the legal limits of the 1031 tax exchange process.

One of the things that sets the 1031 tax exchange process apart from other real estate transactions is the sanctity of the official identification period. In a 1031 exchange, the exchanger must formally “identify” the property that he or she intends to purchase within 45 days of the sale of the first property. It is critical that you remember, however, that this identification process is subject to specific rules and regulations – and it must be completed properly in order for your exchange to be legal.

In order to properly identify your replacement property, it is critical that you formally state your interest in purchasing this property in a written document. This document must bear your signature, and it has to be hand-delivered, mailed, or faxed to a third party involved in the exchange before the end of that 45-day identification period. These rules mean that a verbal statement of intent to purchase is not acceptable: the identification MUST be in writing. Furthermore, note that the formal identification has to be delivered to your third party within the identification period – so leaving that letter languishing on your desk will do you nothing but harm. Additionally, note that the property must be “unambiguously described” in your letter – meaning that you must note the exact legal address of the property.

As a real estate investor, you know that there are many important things to keep in mind when working with the 1031 tax exchange process. One of the keys to completing a successful 1031 tax exchange, clearly, is properly identifying your replacement property according to the rules set out by the IRS. This means adhering to rules about time limits, number of properties, and total property values. It also, however, can mean paying attention to incidental property attached to the larger real estate transaction.

Incidental property is generally considered part of the larger real estate entity as a whole – and this carries through during the identification process. When you formally identify your intended replacement property (or properties), then, any incidental property is considered to be part of the overall real estate entity. Keep in mind that any incidental property (appliances, furniture, machinery, etc.) must be worth no more than 15% of the value of the real estate itself. In an apartment building worth $500,000, then, the total value of the incidental property must be no more than $75,000. It is also important to remember to include the value of incidental property in your identification guidelines – especially if you are cutting close to, say, the 200% rule. Generally, this is not an issue (as incidental property is likely to be rolled into the overall price of the property) – but it is worth remembering.

The 1031 tax exchange process is designed to be used by investors working with real estate that is being sold and purchased. Every investor, however, knows that cases where just actual real estate is involved are rare: most real estate transactions involve more property than just the actual land or building. Residential properties, for example, are likely to include appliances and may be stocked with furniture. Industrial properties may have machinery or equipment. In many cases, then, this incidental property is included with the sale. How does this affect your 1031 exchange?

As a general rule, incidental property that is transferred together with the real estate property in a standard transaction is simply included in the overall value of the property in question. This means that you don’t generally have to worry about incidental property affecting your 1031 tax exchange it is rolled into the overall price of the property and is not counted separately. One detail to keep in mind, however, is that the total market value of the incidental property cannot exceed 15% of the real estate’s market value. In the vast majority of transactions, this is not going to be an issue – but you should keep this in mind if you are working with properties that include a large quantity of machinery or equipment.

In the ideal 1031 exchange situation, the total value of relinquished property is equal to the total value of replacement property. In some cases, however, the exchanger has difficulty making this happen down to exact numbers: it can be hard to ensure that the amounts work out just so. The key to understanding how this works in terms of tax purposes, then, has much to do with looking at how the amounts of relinquished and replacement property compare to one another.
What you are looking for in the calculation is any gain: any funds that you have left over at the conclusion of the exchange. The most common way for gain to occur is in a property exchange where the exchanger (generally inadvertently) trades down. Consider the following situation: I am selling a property for $300,000. I originally purchased the property for $200,000 – meaning my gain is $100,000 on the property. The best replacement property for my needs, however, costs just $250,000. At the end of the transaction, I’ll have $50,000 left in my pocket. Of my $100,000 gain, then, I’ve only “exchanged” $50,000 – meaning I’ll be required to pay capital gains taxes on the remaining $50,000. Note that this example is extremely simple: you’ll need to consult with your tax professional for an in-depth look at how your situation works out.

As a savvy 1031 exchanger, you understand that keeping the right relationship between the value of your relinquished property and the value of your replacement property is critical. You want to ensure that you get the most possible value out of your exchange – without being left with taxable boot. One important thing to understand, then, is the relationship between mortgage debt and cash paid or received in a 1031 exchange situation.

To put it simply, mortgage debt (or, conversely, mortgage debt relief) and cash paid (or cash received) are counted as equivalent in 1031 exchange calculations. This means that your job as a 1031 exchanger is to ensure that your exchange is even in terms of relinquished and replacement property – NOT that the exchange is even in terms of debt relieved and assumed. Consider, for example, the following situation. I am selling a property for $200,000. At the time of the sale, I have $100,000 remaining on that property’s mortgage – which means that the sale will bring me $100,000 in cash and $100,000 worth of debt relief. When I purchase my replacement property for $200,000, however, I use my $100,000 cash – plus an additional $50,000 I have on hand. My new debt, then, is just $50,000. For 1031 tax exchange purposes, this exchange is even and legal: I am NOT required to assume $100,000 in new mortgage debt because the total amounts received and relinquished (counted as the sum of cash and debt relieved or assumed) are equal.

Savvy 1031 tax exchangers understand that when it comes to pulling off the perfect 1031 exchange, it is critical to maintain the right relationship between the values of relinquished and replacement properties. Essentially, then, in order for a 1031 exchange to work properly, exchangers should seek to “trade up” (or at least “trade even”) by purchasing replacement property that is equal or greater in value than the relinquished property.

One additional item that buyers should consider, then, is the fact that any amount of mortgage debt relief is counted as cash received. Receiving relief from mortgage debt of $100,000, then, is the same in tax terms as receiving $100,000 cash. Exchangers need to keep this in mind when considering the values of relinquished and replacement properties. Consider the following example: I’m selling a property worth $150,000. Of this, $50,000 will be received as cash and $100,000 will go towards relieving my current mortgage debt. In my upcoming 1031 property exchange, then, I must put out cash and/or take on mortgage debt totaling at least $150,000 – not just the $50,000 I received as cash – in order to avoid receiving boot and paying taxes. Smart investors, then, know not to forget about debt relief when managing 1031 tax exchanges.

When completing a 1031 tax exchange, there are many things that investors need to consider. There are time limits to track, properties to consider, and pennies to count. One important thing to remember, then, is that all 1031 tax exchanges should be instances of either “trading even” or “trading up” – not trading down.

What do we mean by “trading even?” To put it simply, “trading even” means that the value of your relinquished property or properties is the same as the value of your replacement property or properties. Here’s a simple example: I sell a property for $100,000. I purchase another property for $100,000. I have just “traded even.” To “trade up,” then, means that the value of your replacement property or properties is higher than the value of your relinquished property. In the above example, then, I might sell my property for $100,000 and purchase another for $120,000. I’ve “traded up.”

The only thing you cannot do with a 1031 tax exchange, then, is trade down. A trading down scenario means that your replacement property is worth less than your relinquished property. This situation results in additional tax-sheltered funds being generated – meaning that the concept of “boot” comes into play and the 1031 exchange no longer functions tax-wise the way that you’d like.

When it comes to the 1031 tax exchange process, you understand that there are a number of rules that must be carefully followed in order for the exchange to be legal and effective. As a general rule, 1031 exchange rules are straightforward – but there are places and times when it is possible to slip between the cracks of various regulations.

One small point to remember about 1031 exchanges is that any replacement property received before the 45-day identification period closes will be counted among your replacement property. In a simple one-property-for-one-property exchange, this is relatively unimportant – but this rule can come into play in larger exchanges where multiple properties are at stake. Consider, for example, an exchange operating under the 200% rule for identified replacement properties. You are selling a number of relinquished properties for a total of one million dollars. You’re planning on replacing that asset with a number of smaller replacement properties, but you’re not yet sure which ones. At the start of your exchange period, however, you complete a purchase of one property for $200,000. When it comes to identifying your other replacement properties, then, keep in mind that you must include that $200,000 in your 200% calculation: you may now identify up to $1.8 million in potential replacement properties – not two million.

When it comes to the identification rules of the 1031 tax exchange process, there are a number of things that are straightforward: you know that you only have 45 days to complete the process, for example, and you know that you must formally identify your intended replacement property or properties to the right entities and individuals. Where things get a bit dicey, however, is tackling the ins and outs of the identification process: when can you identify multiple properties? How can this process assist you in your upcoming exchange?

One rule that helps to solidify the details of the 1031 exchange identification process is the 95% rule. The 95% rule states that you may identify as many potential replacement properties as you like – as long as the total value of the actual properties exchanged is not more than 95% of the total value of all properties identified. In this situation, you might identify a number of low-value properties – but wind up leaving one or two out of the exchange for one reason or another. The 95% rule, then, affords 1031 exchangers the ability to have flexibility about their identified and exchanged replacement properties. With the 95% rule, you are able to make tweaks and adjustments to your stable of replacement properties as the situation dictates – which can be especially useful for large exchanges.