Common exchange questions & answers.

Tax deferred exchanging has been around a long while. In fact in some form, it has been with us since the 1920s. However, the difficulty associated with completing an exchange from then up until the late seventies was directly related to those issues which arose around having to complete every transaction simultaneously. Up until the case law which came out of the Starker decisions, every exchange had to be done where all the transfers were completed on the same day — not an easy task at all.

What happened with the Starker situation was this: the Starker family sold some timberland to Crown Zellerbach. Instead of receiving cash in the sale, they took a credit on the books of the company. Then, over the course of about five years, as the Starker family found replacement property they wanted, Crown Zellerbach would buy it and have it deeded to them and applied against their credit.

The IRS was unimpressed with this approach, so they disallowed it and everything ended up in tax court. But interestingly, what arose from the proceedings was that the delayed exchange concept was upheld. For the period between the Starker rulings and 1984, delayed exchanges could be completed legitimately in the circuit which heard the original case.

Exchange volume increased so much that the IRS codified delayed exchanging in 1984 to get some control around the process. That's where our 180-day time frame and identification rules came from. Since then we've gotten rules for reverse exchanges and several Revenue Procedures dealing with many other forms of exchanging.

Equity and gain are both important to an exchange, but they are never the same number. First, equity represents the hard-earned value that is yours in any property you own. If you take your gross selling price and subtract your closing expenses, and then further subtract the amount of any debt, that remaining number is your equity.

To determine gain, we need to know your cost basis. Your cost basis starts with your purchase price and changes over time — if you've done improvements, that amount is added; if you've deducted depreciation, that is subtracted. Your final adjusted basis is your original purchase price, plus any improvements, less any depreciation. Take your net selling price, deduct your final adjusted basis, and that's your capital gain.

One simple rule for a totally tax-free transaction: (1) buy a replacement property that is equal or greater in value than your net selling price, and (2) move all your equity from the old property into the new one. Do those two things, plus replace your debt, and you'll be in excellent shape.

Any tax deferred exchange completed pursuant to Section 1031 needs to involve like-kind properties. It is important to remember that like-kind refers more to the way a property is used rather than the way it looks.

For instance, a typical single-family detached home can be either a personal residence or an income property. The definition for like-kind boils down to using your property in one of two ways: property held for investment, or property held for productive use in a trade or business — basically, property held for income.

As you look for candidate replacement properties, make sure your use of that new property fits within one of those two categories. That is the definition of like-kind.

Because exchanging represents an IRS-recognized approach to the deferral of capital gain taxes, it is important to appreciate the components and intent underlying such a tax deferred transaction.

It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by the Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction.

There are two time-sensitive rules you need to remember. First, you have a total of 180 days in which to sell your relinquished property and actually buy and close on your replacement property or properties. That is called the exchange period. If you buy more than one, make sure the last one you close is still within that 180-day window.

There's an important qualifier: you actually have 180 days or whenever your tax return is due, whichever comes first. If you close late in the year — say around Thanksgiving — you won't have a full 180 days before your return is due April 15th. To get the full 180 days, you'd need to file an extension.

Second, after you close your relinquished property, you have 45 days to name candidate or target properties. The most common identification rule (used 95% of the time) is the Three Property Rule: you can name any three properties of any value. Your identification must be in writing and transmitted or postmarked within that 45-day period.

Although the vast majority of exchanges occurring presently are delayed exchanges, there are a few other exchanging alternatives.

Simultaneous Exchanges: To qualify, both the relinquished property and the replacement property must close and record on the same day.

Improvement and Construction Exchanges: When the replacement property requires construction or significant improvements, this can be accomplished as part of a structured exchange, with payments to contractors made by the facilitator out of trust account funds.

Reverse Exchanges: Where the Exchanger locates and wants to acquire a replacement property before the actual closing of the relinquished property.

Delayed or Deferred Exchanges: The most common type — named for the Starker case. The relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2, within 180 days.

Any property owner or investor who expects to acquire replacement property subsequent to the sale of their existing property should consider an exchange.

To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20–30%, depending on the combined federal and state tax rates. When purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70–80% of what it did previously.

When you carry back financing for your buyer in a 1031 exchange, the Promissory Note you carry will be considered 'non-like-kind property' for the purposes of your exchange. The amount you carry back cannot be included in your exchange because the Promissory Note is considered an evidence of indebtedness, rather than real property.

This means the Promissory Note will be taxed like an installment sale pursuant to Section 453 of the Internal Revenue Code — you will pay tax on principal as it is received.

Carry Back Alternatives: Some Exchangers include a carry back Promissory Note in their exchange by making the Note payable to their Qualified Intermediary. It is also possible for the Exchanger to buy their own Note, representing another method for converting evidence of indebtedness back into cash which can be used to buy additional replacement property.