In a tax deferred exchange, a property owner trades one or more real properties for one or more other real properties and there is no federal income tax on the transaction, and often with no state income tax. In an ordinary sale transaction, the property owner is taxed on any gain realized from the sale of the property. But in an exchange, the tax on the transaction is deferred until sometime in the future, usually when the newly acquired property is sold.

Exchanges can be done by individuals, trusts, corporations, partnerships, limited liability companies, or any other business entity.

You must reinvest the net proceeds from the disposition of the relinquished property in like-kind real property rather than other types of more liquid investments, such as stocks or bonds. The like-kind real property must be identified and acquired within the short time periods set forth in the statutory language, as discussed below in “How is an Exchange Structured?”. There may be additional fees in an exchange, including attorney’s fees, accounting fees, and qualified intermediary fees. The replacement property will have a carryover tax basis from the relinquished property. This means that more taxable gain will be realized when the replacement property is later sold than would have been realized if the replacement property had been acquired through a straight purchase. In addition, if the replacement property is depreciable, the future depreciation deductions will be lower in an exchange because the tax basis of the replacement property is reduced by the gain deferred in the exchange.

Exchanges can be forward or reverse and can also include newly built improvements. In a forward exchange with a Qualified Intermediary (QI), you transfer title to the relinquished property to the buyer. The proceeds from the transfer go directly into the exchange account set up for you by the Qualified Intermediary. The proceeds are later used to purchase your replacement property, and the seller will transfer title to the replacement property directly to you. You have 45 days following the sale of the relinquished property to identify the replacement property to the QI in writing. You must acquire the replacement property by the 180th day following the transfer of the relinquished property. These time limits are statutory. There are no extensions or exceptions, other than in the rare circumstance of a federally declared disaster. (Note that if the 180th day falls after the due date of your federal income tax return for the year the relinquished property was transferred (e.g. April 15th), then you must file a tax return extension form with the IRS to get the full 180-day replacement period.)

In a reverse exchange, the replacement property is acquired prior to the sale of the relinquished property. It must be structured correctly to qualify. You cannot own both the relinquished property and replacement property at the same time. This means that an “exchange accommodation titleholder” (EAT) either: (1) acquires title to the replacement property from the seller while you line up a sale of the relinquished property; or (2) acquires title to the relinquished property from you at the time that you acquire title to the replacement property. In either case, the maximum time period of a reverse exchange is 180 days, and you must have some means of financing the acquisition of the replacement property prior to availability of the relinquished property proceeds.

New improvements can be made to replacement property during the 180-day period in either a forward or reverse exchange, and these improvements will count towards the exchange value of the replacement property. This type of exchange must be structured correctly for the improvements to qualify as replacement property. This means the improvements must be made before you take title, by either the seller or in a forward or reverse “EAT” style arrangement.

The other requirements of the IRS regulations must also be met in addition to the time limitations.

If you actually or constructively receive the exchange funds, the exchange will be taxable. Therefore, the exchange funds must be held by the qualified intermediary, or a third-party escrow holder or trustee. All exchange funds held by our firm are placed in qualified escrow accounts with an independent bank. Your exchange funds are not commingled with the funds of any other client for investment purposes.  The exchange account requires your authorization for any withdrawals.

There are several requirements for a valid exchange:

1. Real Property Only.As of January 1, 2018, only real property can qualify for tax-deferred treatment.
2. The Purpose Requirement.The taxpayer’s relinquished property and replacement property must be held for productive use in a trade or business or for investment. Property acquired primarily for sale will not qualify. Property held or acquired as a principal residence or primarily as a vacation or second home will also not qualify.
3. The Like-Kind Requirement.Replacement property acquired in an exchange must be “like-kind” to the real property being relinquished. All real property is generally like-kind to other real property, so this requirement is typically easy to meet, but there are some exceptions.
4. The Exchange Requirement.IRC §1031 specifically requires that an exchange take place. That means that property must be exchanged for other property, rather than sold for cash. The exchange distinguishes an IRC §1031 tax deferred transaction from a taxable sale and purchase. Today, a deferred exchange is accomplished through a Qualified Intermediary to insure that the exchange meets the requirements of IRC §1031.

Identification of all replacement property must be made in writing, signed by the taxpayer, and sent to a party to the exchange on or before midnight of the 45th day of the exchange period. The written identification is usually sent to the Qualified Intermediary. The identification of the replacement property must be unambiguous. For example, the identification can provide either a street address or legal description of the property. If improvements are to be constructed on the property, they must be described in as much detail as is reasonably practical.

The taxpayer may identify one or more properties in the written identification. The maximum number of replacement properties that may be identified is:

1). Up to three properties, without regard to their fair market value (The Three-Property Rule);

2). More than three properties, but the total fair market value of all these properties at the end of the 45-day identification period cannot not exceed 200% of the total fair market value of all properties relinquished in the exchange (The 200% Rule).

For example, if the relinquished property value is $500,000, the written identification can include up to three properties of any value. If the identification contains more than three properties, then the total estimated value of the identified properties cannot exceed $1,000,000.

Any property actually received during the 45-day identification period is treated as properly identified, but does count as a property for the purposes of the Three Property Rule or the 200% Rule if the taxpayer identifies additional replacement property in a written notice. If the taxpayer exceeds both the Three-Property Rule and the 200% Rule, then the properties acquired after the 45th day do not count as replacement property in the exchange (unless the taxpayer acquires 95% of all the identified properties).

As a rule of thumb, you must trade up or equal in value AND equity to totally defer all of the taxable gain in your exchange. For example, if your relinquished property is transferred for $500,000 and the mortgage is $300,000, to defer all the tax on the gain, you must acquire replacement property valued at least at $500,000 with at least equity of $300,000. You will be taxed to the extent you trade down in either value or equity (but not in excess of the tax you would have owed in a taxable sale). Thus, in the above example, if the replacement property was valued at $400,000, the taxable gain from the exchange would be $100,000 (assuming the tax basis in the relinquished property was below $400,000).

PLEASE NOTE THAT there are many exceptions to this rule and your taxable gain can be impacted by closing costs, including rent prorations and security deposits. Your taxable gain also can be impacted by several tax provisions, including depreciation and other recapture items, net operating losses, and special corporate and partnership tax provisions. We do not review your tax returns for items that may affect your taxable gain, and we do not undertake to calculate taxable gain in your exchange. YOU SHOULD CONSULT YOUR TAX ADVISOR PRIOR TO COMMENCING THE EXCHANGE REGARDING THE COMPUTATION OF POTENTIAL GAIN FROM THE EXCHANGE AND ANY SPECIAL TAX ITEMS THAT MAY IMPACT YOUR TAX CONSEQUENCES.