1031 Like Kind Exchange Rules & Requirements

Delayed Exchange Deadlines and Identification Requirements

The most common exchange variation is the delayed exchange format. One of the central requirements in a delayed exchange is that the replacement property is properly identified within the identification period and acquired by the end of the exchange period. The Treasury Department issued Regulations in 1991 that clarified the acceptable methods to properly identify 1031 exchange replacement property. See Treas. Regs. §1.1031(k)-1(b) through (e). It is essential in a delayed exchange to adhere to these rules and deadlines established for identifying and acquiring the replacement property. Failure to comply with these rules may result in a failed exchange.

There are two key deadlines that the Exchanger must meet to have a valid exchange:

• Exchange Period: The Exchanger must receive the Replacement Property within the earlier of 180 days after the date on which the Exchanger transferred the first Relinquished Property, of the due date (including extensions) for the Exchanger’s tax return for the tax year in which the transfer of the first Relinquished Property occurs.
• Identification Period: The Exchanger must identify the Replacement Property to be acquired by the end of the Exchange Period within 45 days of the transfer of the first Relinquished Property.
• The time periods for the 45-day Identification Period and the 180-day Exchange Period are very strict and cannot be extended even if the 45th day or 180th day falls on a Saturday, Sunday or legal holiday.

1031 Exchange Replacement Property must be properly identified within the Identification Period by at least one of the following methods:

• Completing the purchase of the Replacement Property within the Identification Period; or
• Identified in a written document (“Identification Notice”) signed by the Exchanger and hand delivered, mailed, telecopied, or otherwise sent by midnight of the 45th day, which is the end of the Identification Period.

The written Identification Notice should be made to:

• The person obligated to transfer the Replacement Property to the Exchanger, even if that person is a disqualified party. Examples of persons obligated to transfer the Replacement Property to the Exchanger are the seller of the Replacement Property or the Exchanger’s Qualified Intermediary; or
• To any other person involved in the exchange other than the Exchanger or a disqualified party. Examples of persons who are involved in the exchange and who are not considered disqualified parties are an escrow, settlement or title officer or a person who is providing the Exchanger with services solely relating to the exchange of property.

The Identification Notice must contain an unambiguous description of the Replacement Property and must be signed by the Exchanger. A fully executed purchase and sale agreement specifying the Replacement Property may satisfy these requirements. Otherwise, in the case of real property, the Identification Notice must include the legal description, a street address or a distinguishable name. In addition, when the Exchanger intends to improve the Replacement Property during the Exchange Period the Exchanger must include an adequate description of the underlying land and a description in as much detail as is practicable at the time of the identification of the proposed construction or improvements. When identifying Replacement Property in a real property exchange, any personal property included in the purchase that has a value of less than 15% of the total value of the Replacement Property is considered incidental and does not need to be separately identified. An identification of Replacement Property may be revoked prior to the end of the Identification Period. The revocation must be done in a writing signed by the Exchanger and made to the same person to whom the original identification notice was sent.

Exchangers have the flexibility of identifying more than one property as Replacement Property for their exchange. The options for identification are:

• Three Property Rule: The Exchanger may identify as potential Replacement Property any three properties, without regard to their fair market value.
• 200% Rule: The Exchanger may identify as potential Replacement Property any number of properties provided the aggregate fair market value of all of the identified properties does not exceed 200% of the aggregate fair market value as of the date of the transfer of all of the Relinquished Properties.
• 95% Exception: If the Exchanger identifies more potential Replacement Properties than allowed under either the Three Property or the 200% Rules, the Exchanger must receive Replacement Property by the end of the Exchange Period that has a fair market value of at least 95% of the aggregate fair market value of all of the identified Replacement Properties. The fair market value of property is determined as of the earlier of the date the property is received by the Exchanger or the last day of the Exchange Period and without regard to any liabilities secured by the property.

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Brief Exchange Communications
HighStreet Net Lease Group, LLC cannot provide advice regarding specific tax consequences. Investors considering an IRC §1031 tax deferred exchange should seek the counsel of their accountant and attorney to obtain professional and legal advice.

Defining the Exchange Process

The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers investors one of the last great opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of their equity into the replacement property.  Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire “like kind” replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).

In any exchange the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by direct deed from the Exchanger and (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account.  The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.

Important Considerations for an Exchange

• Exchanges must be completed within strict time limits. The Exchanger has 45 days from the date the relinquished property closes to “Identify” potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. After the 45 days has passed, the Exchanger may not change their Property Identification list and must purchase one of the listed replacement properties or the exchange fails!
• To avoid the payment of capital gain taxes the Exchanger should follow three general rules: (a) purchase a replacement property that is the same or greater value as the relinquished property, (b) reinvest all of the exchange equity into the replacement property and (c) obtain the same or greater debt on the replacement property as on the relinquished property.  The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.
• The Exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes.
• IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in a partnership.

HighStreet Net Lease Group, LLC is available to assist Exchangers and their advisors with their exchange strategies.  The Exchanger is always advised to discuss the intended exchange with their legal or tax advisor.

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Brief Exchange Communications
HighStreet Net Lease Group, LLC cannot provide advice regarding specific tax consequences. Investors considering an IRC §1031 tax deferred exchange should seek the counsel of their accountant and attorney to obtain professional and legal advice.

“Like-Kind” Property

To qualify for tax deferred exchange treatment under IRC §1031, the relinquished property must be exchanged for replacement property that is of “like-kind”. For real property exchanges the term “like-kind” refers to the nature or character of the property and not to its grade or quality. For example, it does not matter whether the real property involved is improved or unimproved because that fact only relates to the grade or quality of the property and not to its kind or class. Treas. Reg. §1.1031(a)-1(b). In essence, all real property is “like-kind” with all other real property. Generally, however, for personal property exchanges the relinquished and replacement property must both be in either the same General Asset Class or the same Product Class. To qualify for an exchange the Exchanger must have held the relinquished property for investment, or for “productive use in their trade or business,” and must intend to do the same with the replacement property. The following are examples of “like-kind” properties:

• Residential for commercial
• Bare land for rental property
• Fee simple interest for 30-year leasehold
• Single family rental for multi-family rental
• Non-income producing raw land for income producing rental property
• Rental mountain cabin for a dental office in which the Exchanger intends to practice
• Corporate twin-engine aircraft for a corporate jet
• Mitigation credits for restoring wetlands for other mitigation credits
• Buses for buses
• Garbage routes for garbage routes
• Livestock of the same sex (Note: livestock of different sexes are not of “like kind”)

Exchanges of Foreign Property

Exchangers may exchange properties throughout the United States. When taxpayers relocate within the United States they can essentially “take” their investment properties with them by completing an exchange. For example, the Exchanger who is moving from California to Montana may relinquish in California and acquire near their new home in Montana.

Prior to 1989, however, Exchangers were able to perform an exchange of a United States property for a foreign investment property, such as a rental house in Los Angeles for a rental villa in France. After the Revenue Reconciliation Act of 1989, IRC §1031 was amended such that real property located in the United States and real property located outside the United States are not like-kind. Treas. Reg. §1.1031(h). It is somewhat unclear by what “property located in the United States” means, but there is some indication that property located in the Virgin Islands may qualify as “property located within the United States” for purposes of favorable exchange treatment. Private Letter Ruling 9038030 (June 25, 1990). Moreover, a taxpayer who sells foreign property and buys foreign property, and who is subject to capital gains tax on their U.S. tax return, may want to consider an exchange since foreign property is considered to be of like-kind to other foreign property. For example, the taxpayer who relinquishes a rental property in Canada and acquires another like kind property in Canada, or relinquishes a rental apartment in Singapore and acquires a rental condominium in Hong Kong, may benefit from a tax deferred exchange. It is important to note that in exchanges involving personal property the determining factor as to whether the personal property is foreign or domestic is the location of the predominant use of the property because personal property used predominantly within the United States and personal property used predominantly outside the United States are not of a like kind. The code generally requires a two year holding period for both the relinquished and replacement properties in determining the predominant use “like kind” requirement for the exchange.

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Brief Exchange Communications
HighStreet Net Lease Group, LLC cannot provide advice regarding specific tax consequences. Investors considering an IRC §1031 tax deferred exchange should seek the counsel of their accountant and attorney to obtain professional and legal advice.

DO

Do advanced planning for the exchange. Talk to your accountant, attorney, broker, lender and Qualified Intermediary.

DO NOT

Do not miss your identification and exchange deadlines. Failure to identify within the 45 day identification period or failure to acquire replacement property within the 180 day exchange period will disqualify the entire exchange. Reputable Qualified Intermediaries will not act on backdated or late identifications.

DO

Do keep in mind these three basic rules to qualify for complete tax deferral:

• Use all proceeds from the relinquished property for purchasing the replacement property.
• Make sure the debt on the replacement property is equal to or greater than the debt on the relinquished property. (Exception: A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt.)
• Receive only “like-kind” replacement property.

DO NOT

Do not plan to sell and invest the proceeds in property you already own. Funds applied toward property already owned purchase “goods and services,” not “like-kind” property.

DO

Do attempt to sell before you purchase. Occasionally Exchangers find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a reverse exchange (buying before selling) may be necessary. While the IRS has recently provided guidance for reverse exchanges in Revenue Procedure 2000-37, Exchangers should be aware that reverse exchanges are considered a more aggressive exchange variation because some other entity must hold title to either the Exchanger’s relinquished or replacement property for up to 180 days pending the completion of the exchange transaction.

DO NOT

Do not dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchanger’s legal relationship with the property may jeopardize the exchange.

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Brief Exchange Communications
HighStreet Net Lease Group, LLC cannot provide advice regarding specific tax consequences. Investors considering an IRC §1031 tax deferred exchange should seek the counsel of their accountant and attorney to obtain professional and legal advice.