“STEPS OF A REAL ESTATE EXCHANGE TRANSACTION”
This article is meant as an “Overview” explaining the steps involved when implementing a Real Estate Exchange transaction.
A Real Estate Exchange starts off the same ways as a Real Estate Sale, you need a buyer. Once there is a successful meeting of the minds between the seller and buyer, the seller brings into the transaction a Professional Qualified Intermediary. The Taxpayer, (seller) will transfer title in the Relinquished Property to the Qualifie d Intermediary, in exchange the Qualified Intermediary promises to
acquire and convey to you, (meaning the Taxpayer) at your direction other like-kind property known as the Replacement Property.
The Qualified Intermediary will utilize the net proceeds received on the sale from the Buyer of the Relinquished Property, after adjustment for transactional expenses to purchase the Replacement Property. Pursuant to a written Exchange Agreement the Taxpayer assigns the Qualified Intermediary the rights under the Contract of Sale to sell the Relinquished Property. For convenience purposes and to avoid additional payment of double transfer taxes, you and the Qualified Intermediary agree to have the Relinquished Property deeded directly from you (the Taxpayer) to the purchasers.
This arrangement with the Qualified Intermediary is intended to comply with requirements for a Deferred Exchange under the provisions of Internal Revenue Code Section 1031. The reason for the Qualified Intermediaries involvement is to provide services of a “Qualified Intermediary” and also as a “Qualified Escrow”, party to the Exchange transaction who is not deemed your agent (known as a
“Disqualified Person”) for tax purposes. Since the receipt of proceeds (actual or constructive) from the disposition of the Relinquished Property by you, or your agent, would invalidate the attempted Exchange transaction.
Internal Revenue Code Section 1031 provides two specific time restrictions which if not met, will disqualify a Deferred Exchange for non-recognition treatment. The first is that the Replacement Property to be acquired must be identified within 45 days (“Identification Period” ) after you transfer the Relinquished Property. The second is that all Replacement Properties which you will acquire must be transferred to you no later than the earlier of (i) 180 days (“Exchange Period”) after the date you dispose of the Relinquished Property (including, in said computation, both the day of disposition of the Relinquished Property and of acquisition of the Replacement Property), or (ii) the due date (with Extensions) of your federal income tax return. These deadlines are both absolute; i.e. you are not entitled to any extensions of the deadlines under any circumstances.
Treasury Regulations Section 1.1031 (k)-1 (the “Deferred Exchange Regulations”) set forth additional rules which govern the Exchange transaction. The regulations make clear that identifications should be made to the Taxpayers Exchange partner (the “Qualified Intermediary”). No official form ofidentification has been created, but the Qualified Intermediary, will provide an identification form which you should complete and return designating the Replacement Property or Properties you wish to acquire. This form must be returned to the Qualified Intermediary within the 45 day “Identification Period”, because failure to timely identify the Replacement Property will disqualify the Exchange transaction for a tax-deferred treatment.
The Deferred Exchange Regulations provide two basic options relating to the number of alternative properties which may be identified as potential Replacement Properties. You may identify three alternative (of any value), known as the “3 Property Rule”, without regard to which of the three you intend to acquire. If you identify more than three (3) properties, then you must limit the total value of
all identified properties to 200% of the value of the Relinquished Property known as the “200% Rule”. Failure to restrict yourself to one of these two options may mean your entire Exchange is invalid, since if you exceed these limits you would have to acquire virtually 95% of the total value you identified known as the “95% Rule”. However, you are permitted to make changes in the identification of properties by revoking in writing to the “Qualified Intermediary” and substituting in writing others, during the 45 day “Identification Period” so long as you satisfy the applicable limits at the end of the period.
Because of the critical importance of proper, timely identification of Replacement Property, you must understand these requirements and pay particular attention to keeping record of properties identified, identifications revoked, etc. this is your responsibility as the Taxpayer to monitor.
When you have located and negotiated an acquisition agreement (Purchase Agreement) for Replacement Property, the Qualified Intermediary will provide an Assignment Agreement. The execution of this Assignment will assign your purchase rights to the Qualified Intermediary, which will complete the purchase, using funds up to the total available “Acquisition Credit” in the Qualified Escrow Account”.
In the event that Acquisition Credit is not sufficient to acquire the designated Replacement Property then you as the Taxpayer, will need to add the necessary amount of cash (or finance the difference) to close the transaction. The Qualified Intermediary will transfer the Replacement Property to you again, for convenience purposes and to avoid double transfer taxes, the Qualified Intermediary may arrange for the Replacement Property to be directly deeded to you from the sellers thereof.
This is an overview of how a Deferred Exchange transaction needs to be structured today, in order to be valid in the eyes of the I.R.S.
WHY PEOPLE EXCHANGE REAL ESTATE:
- To pyramid
- To make a profit
- To build an estate
- To increase income
- To avoid a cash sale
- To assemble properties
- To reduce indebtedness
- To eliminate borrowing
- To build larger equity
- To avoid a double move
- To increase amortization
- To consolidate holdings
- To avoid capital gains tax
- To reduce overall holdings
- To upgrade size of investments
- To defer “recapture” provisions
- To expand commercial premise
- To balance investment portfolio
- To upgrade quality of investments
- To acquire more speculative property
- To acquire more conservative property
- For continuity of income and ownership
- To increase leverage; or, decrease leverage
- To assume a larger mortgage indebtedness
- To anticipate or minimize functional obsolesce
- To generate cash
- For immediate income rather than future income
- For future income rather than immediate income
- For capital appreciation rather than current income
- To restore depreciation which ran out on an old property
- To reduce commercial premise, or abandon expansion plans
- To divide one property into several, for diversification of risk.
- To boost basis for future sale/exchange or depreciation
- To eliminate management by acquiring no management property
- For economy of time, in finding new property after sale of old
- For faster depreciation via older property or better land/improvement ration
- For more depreciation via newer property or better land/improvement ration
- To change investment location…for safety, diversity, in anticipation of trends or convenience
- To exchange leaseback commercial premises unlocking frozen equity for new investment
- To create increased capital values by modernizing, improving, upgrading older or run down property
- To assume management and earning greater yields through active participation while bringing personal fulfillment
- Because changes and trends have reduced income or prospective income so that old property is no longer highest and best use
- To move personal residence, business, or investment realty; beach, desert, city, country, hills, mountains farms from any one to other
- To move personal, business or investment realty older district, newer district, larger, newer, smaller property, from any one to the other
- Some folks like the excitement of making a move.
- They just don’t want what they own unlocking frozen equity for new investment
TAX DEFERRED EXCHANGES
SECTION 1031 of the INTERNAL REVENUE CODE
PAY NO CAPITAL GAINS TAX
CERETIFIED EXCHANGE ADVISOR (CEA)
The CEA is an individual designation and the mark of a professional in the field of real estate exchanging. It signifies that you have completed strict educational requirements.
Russ Russell is Huntsville’s First and Only Certified Exchange Advisor (CEA). This designation is awarded to individuals who have completed intensive classwork on the specialty of real estate exchanging provided through the American Institute of Real Estate Exchangers.
Real Estate exchanging pertains to Section “1031” of the Internal Revenue Code. It allows individuals to “PAY NO CAPITAL GAINS TAX” when disposing of business or investmentheld real estate. This tax law has been part of the Internal Revenue code since 1921. This is the best way to not pay Capital Gains Tax on the sale of real estate!
RUSS RUSSELL, CCIM, SIOR, CEA