This is why it has never been more important that you ensure that your upcoming Section 1031 exchange is informed by experts, planned appropriately, and executed flawlessly. Let's be honest, you've worked too hard to create the equity that you have. You owe it to yourself to warrant that your personal data, transactional logistics, and especially your exchange funds are fully secured at all times and your exchange is facilitated within the 1031 industry's first, fully encrypted exchange processing environment.
Often called the last great wealth building tool available to real estate investors, a tax deferred exchange is an Internal Revenue Service approved approach where a property owner can sell a highly appreciated asset and replace it with another like-kind property on a tax deferred basis, provided the transaction was completed within some basic guidelines set for the by the IRS.
Although the logistics of selling one property and buying another are virtually identical to any standard sale and purchase scenario, an exchange is different because the entire transaction is memorialized as an exchange and not a taxable sale. It is this distinction between exchanging and not simply selling and buying, which ultimately allows the taxpayer to qualify for deferred gain treatment. So essentially, sales are taxable and exchanges are not.
There are several excellent reasons why an investment or income property owner should consider an exchange when they are selling a qualifying property. The first and most obvious is that the normal capital gains tax which is traditionally due upon a sale can be deferred until a later date and a later sale.
This is because the IRS allows a tax deferred transaction because they view it as an investment or income property owner simply transferring their cost basis for tax purposes from one qualifying property to another. Make no mistake, your capital gain tax exposure does not go away outright, it is simply transferred to the new replacement property which is acquired in the exchange transaction.
How does the capital gain tax transfer to the new property? It is transferred to the replacement property as a new adjusted cost basis that is created upon your purchase. The new adjusted basis will essentially be the replacement property purchase price less the amount of the capital gain you have deferred.
Some of the other reasons for considering an exchange include:
The IRS has set forth a few modest requirements for an exchange to qualify for deferred gain treatment. Among the main requirements are:
The three IRS rules for the correct identification of replacement properties.
1) The Three Property Rule dictates that the Exchanger may identify three properties of any value, one or more of which must be acquired within the 180 Day Exchange Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all identified properties may not exceed 200% of the value of the Relinquished Property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, they typically fail because of discrepancies in identification.
The IRS expects you to replace both your equity and your debt in order to create a fully tax deferred transaction. This is not to say that you cannot do a partial exchange, you can! However, if you'd like to ensure that your exchange will be totally tax deferred, do these three things:
IRS compliant exchanges can be completed in several forms, depending upon the Exchanger's circumstances and the transactional logistics and structure of the exchange itself. Among them are:
Some investors still try to complete simultaneous exchanges, primarily to avoid or reduce the payment of multiple closing fees or exchange fees for a Qualified Intermediary, essentially using the relinquished ad replacement closing statements in lieu of an exchange agreement.
There is significant danger and legal exposure in this attempt since many unforeseen events can cause the closing to be delayed on one of the properties, leaving the investor with a failed exchange and the obligation of taxes that would otherwise be deferred. For example, if the properties are located in different counties, it is highly unlikely that the closing can take place on the same day. If two different escrow firms or closing attorneys are involved, it is virtually impossible for both to have the funds to close in their possession on the same day. For instance, with "Good Funds" laws existing in many states, an escrow holder or closer cannot disburse funds not actually in their possession. Further, in directing an escrow holder or closer to disburse funds for the purchase of the replacement property, The IRS could contend that the investor had what is considered "constructive receipt" of the proceeds of the sale, and therefore taxes on the gain would be due.
However, the 1031 regulations do contain what is referred to as a "Safe Harbor" provision, which does provide that in the event a facilitator or intermediary is used in a simultaneous exchange, and the transaction proves not to be simultaneous, the exchange will not fail simply for that reason.
In a delayed exchange, the Relinquished Property is sold at Time 1, and after a delay of up to 180 days, the Replacement Property is acquired at Time 2.
The deferred exchange also requires that the Exchanger must identify candidate or targeted replacement properties within 45 days from the closing of the relinquished property. The identification must be in writing, signed by the Exchanger, and completed pursuant to one of three identification rues set forth by the Internal Revenue Service. Those rules are.
There are occasions when an Exchanger needs to acquire their replacement property prior to selling their relinquished property. But, because the IRS will not allow you to exchange into property that you already own, a special process was created by the IRS in Revenue Procedure 2000-37 to provide logistical guidance for buying before you sell and still having a compliant exchange.
The most popular reverse exchange approach, known as an exchange last reverse, is where an Exchanger arranges the acquisition of the replacement property by adding enough cash (or arranging suitable financing) to buy the new property through a surrogate set up by the Qualified Intermediary, known as an Exchange Accommodation Titleholder, or EAT. The EAT holds title to the replacement property until such a time within the 180 day exchange period that the relinquished property is sold. When the relinquished property is sold and the exchange proceeds from that sale are wired to the Qualified Intermediary, two things happen. First, the amount of cash advanced by the Exchanger (in the form of a loan to the EAT) to acquire the replacement property is repaid to the Exchanger. Additionally, the replacement property is deeded to the Exchanger by the EAT, or the EAT limited liability company itself is transferred to the Exchanger by the Qualified Intermediary.
Another technique, known as an exchange first reverse, provides for an opposite approach where the relinquished property is deeded to the EAT at the beginning of the process. This allows the Exchanger to then go ahead and close on the replacement property and take title to the replacement property in their own name. Then, within the 180 day exchange period and when the relinquished property is sold to a new buyer, the relinquished property is deeded to the new buyer by the EAT. It should be noted that in an exchange first reverse, it is best if the equities between the relinquished and replacement properties are balanced prior to deeding the relinquished property to the EAT.
Obviously, due to the transactional and qualifying logistics of reverse exchanges, they tend to be more complicated exchanges, with the resulting reverse exchange fees amounting to much more than the typical deferred exchange. Also, since they tend to be more complex than other exchanges, and because they involve the holding, parking or warehousing of title by a facilitator in the form of an Exchange Accommodation Titleholder or EAT, they require extensive planning.
Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or Qualified Intermediary.
Since tax deferred exchanges involve a minimum of two properties, and often many more, they often include some extraordinary logistics because of the multiple closings and the difficulties associated with many transactional moving parts. For this reason, and because a significant amount of deferred gain treatment is at stake, every exchange deserves to be planned by the Exchanger beforehand.
It usually only takes a few minutes with a 1031 exchange professional for an Exchanger to in theory walk through the entirety of the exchange logistics before starting. This type of pre-planning can often assist an Exchanger by avoiding many pitfalls and create suitable workarounds or mitigation strategies before any problems can arise.
Once the planning is complete, the exchange structure and timing are decided, and the relinquished property is sold, the Qualified Intermediary needs to create the appropriate exchange agreement and set up a trust account for the Exchanger's sale proceeds before the transaction is closed. After closing, the exchange funds are wired to the Exchanger's trust account until the Replacement Property is located and identified.
The funds necessary to acquire the replacement property are then wired or sent to the closing entity in the most appropriate and expeditious manner, and the replacement property is purchased and deeded directly to the Exchanger. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator or Qualified Intermediary. This includes items such as the exchange agreement, assignment agreement, any necessary 1031 notices to other parties, and all appropriate closing instructions.
The process of selecting a Qualified Intermediary has never been more important. This is because, in addition to there being relatively few federal regulations governing the function of intermediaries, how a Qualified Intermediary actually accommodates the facilitation of your exchange, and even more importantly, how they handle your exchange funds, has never been more critical.
Elsewhere, we discuss how pivotal it is that every Exchanger choose a Qualified Intermediary that will facilitate their exchange within an encrypted processing environment, and appropriately provide for the absolute security of the Exchanger's personal data as well as their hard-earned exchange funds.
Select the facilitator as you would an attorney for personal representation or a physician to treat your children. Look for experience in doing exchanges and reputation in the real estate, legal or tax communities.
Also, ask about the security of your funds, and what options you as an Exchanger may have to assure that your funds will be safeguarded. Although the costs and fees for an exchange are relatively insignificant, ask about them, and get a clear explanation of what you will be charged. With a few notable exceptions, fees are very similar, one facilitator to the next. What is of far greater importance is the competence and ability of the facilitator and their personnel to complete your exchange promptly, professionally and compliantly.
Three rules exist for the correct identification of replacement properties within your 45 day timeline.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, typically they fail because of discrepancies in identification.
At our website and also accessible from your Fyntex personal exchanging workspace, we've built an electronic capability which will allow you to identify your replacement property quickly and easily. You simply enter the details of your relinquished property sale, select your ID rule, and list the properties you want to identify. Once complete, your IRS compliant Identification is generated in PDF form complete with time stamps and your e-signature.
Many Exchangers don't understand that the 1031 exchange industry is largely unregulated. Across the country there are very few provisions set forth legislatively to ensure that your exchange as well as your hard-earned exchange funds are handled appropriately.
To be sure, there are a handful of states that do require the licensing of Qualified Intermediaries and some basic requirements for minimum fidelity bonding and errors and omissions insurance for facilitators.
This is just one of the reasons why as an Exchanger, you must take an active role in ensuring that the processing of your exchange is secure and that your exchange funds, while on deposit with the Qualified Intermediary are always safe. You owe it to yourself to understand both the environment in which your exchange documentation and data is handled, but also how your 1031 funds will be held for your benefit.
The Security of Your Personal Data
The online world in which we live today can be dangerous. Especially for those involved in the sale and transfer of real estate. Your personal data is always at risk of being hacked or compromised, and it is even more risky to allow the transport of your personal data across free email platforms like Gmail and Yahoo.
We were recently reminded that this reality extends to every tax deferred exchange transaction as well, when the two largest title company owned Qualified Intermediaries were closed down for short periods of time due to a ransomware attack. This caused incredible havoc, with some Exchangers being unable to complete their exchanges within their 180 day exchange period and having to report a taxable event rather than the tax free transaction they had envisioned earlier. Therefore, insist that your QI takes the security of your personal data as seriously as you do!
Frankly, this is one of the primary rationales Fyntex utilized when we set up our original secure processing platform as a Qualified Intermediary in 2018. We encourage every Exchanger to insist that their exchange is processed within a fully encrypted environment, to ensure that no data is ever at risk. That is also why we will always set up your exchange within our system as the first step in our relationship with an Exchanger and securely send you the appropriate login credentials, so you can log in to a secure ecosystem where you can safely interact with your exchange documents, view your trust account activity, or communicate with your 1031 Coordinator.
This encryption protocol represents the backbone that works to protect you and your business 24/7:
The Security of Your Exchange Proceeds
For many years, Qualified Intermediaries commingled the exchange proceeds of their Exchangers and provided for the sub-accounting of individual Exchanger balances on their own books. Over time, as banking software became more sophisticated, it was possible to set up individual accounts for the benefit of Exchangers (FBO), however the accounts were always in the name of the Qualified Intermediary and never required the approval of the Exchanger to transfer and exchange funds.
The Unique Fyntex and Velocity 1031 Approach to Funds Security
By now, it is obvious that we've tried our best to build the most secure and most transparent value proposition for Exchangers.
We've done this by encouraging:
The Power of Your 24/7 Account Access
In today's digital age, having access to financial information at any time is imperative.
This standard now represents the safest method for having your funds on deposit with any Qualified Intermediary. If a QI suggests to you that this is unnecessary or refuses to offer you a Qualied Escrow Account, you shouldn't immediately assume your exchange proceeds will be safe in their custody.
A New Paradigm in 1031 Funds Security - Full FDIC Insurance for Exchangers
Lastly, while we know it is possible to arrange extended FDIC insurance for individual accounts, coverage is traditionally limited to $250,000 for each account. However, Fyntex has been recently been accepted into the IntraFi program which allows us to extend full FDIC insurance to every 1031 exchange dollar on deposit.
It is difficult to describe how beneficial this single capability is to Exchangers, since the safety of their hard-earned exchange proceeds is always paramount. This is because the FDIC provides immediate liquidity and instant access to your exchange funds exactly when you need them to close your replacement property. Such is not the case if you have to file a claim against an insurance policy or are required to sue before being made whole through a claim made on a Fidelity Bond.
Owners of investment and income properties have access to the greatest real estate wealth building tool ever developed, the 1031 tax deferred exchange.
Exchanges don't have to be difficult, however you need to understand a few keys to 1031 exchanging to have an efficient and fully compliant transaction.
You may exchange investment or income property for many reasons and still defer capital gain and depreciation recapture taxes. The Internal Revenue Service views your exchange of one property and the replacement with another as simply moving your adjusted cost basis from one qualifying property to another. This is why they allow the transfer to be tax deferred.
The Internal Revenue Service requires that the property you sell, as well as the property you buy must be like-kind. And, like kind means one of two things. Either, property held for investment, or property held for income. This usually excludes your personal residence.
The IRS requires that your exchange be completed with the assistance of a Qualified Intermediary or facilitator. You should use a well-established firm like FYNTEX, so you know that your exchange documentation will be always be correct and that your exchange funds will be safely held in a separate trust account in your name and with your tax identification number.
You must complete your sale and purchase within a total of 180 days or whenever your tax return is due. The tax return qualifier means that if you start your exchange late in the year, you might have to file for an extension in order to receive your full 180 days.
While you have a total of 180 days to complete your 1031 exchange, the IRS requires that you identify your candidate or target replacement properties within the first 45 days of your exchange period. This identification is usually made to your Qualified Intermediary by completing a form which is kept in your exchange file. Since the 45 day identification period moves so quickly, start looking for new property as early as possible in the process.
The IRS requires the use of two rules or one exception for identifying potential Replacement Properties.
The first is the Three Property rule, meaning you may identify up to three properties of any value.
The second rule is the Two Hundred Percent rule, meaning you may identify more than three properties provided all of the properties you identify do not exceed two hundred percent of the value of the property you sold.
The one exception is known as the Ninety-five Percent exception. You may identify more than three properties and more than two hundred percent of total identified property value, provided you acquire at least ninety-five percent of everything you identified.
If you want a completely tax deferred transaction you must do these three things. First, buy replacement property which is equal or greater than the net selling price of what you sold. Two, move all your equity from the old property into the new property. And three, replace your debt.
It is always best to buy as the same entity in which you sold. To change your vesting (to an LLC for example) in the middle of an exchange will create unnecessary risk because the IRS could make a case that your new ownership entity had not seasoned their ownership sufficiently to qualify for deferred gain treatment under Section 1031.
Cost Basis: This is where all tax related calculations in an exchange begin. Cost Basis essentially refers to your original cost in acquiring a given property. Therefore, if the original purchase price of the property you anticipate exchanging was $275,000; your Cost Basis is $275,000.
Adjusted Basis: At the time of your sale, it is necessary to determine your current or adjusted basis. This is accomplished by subtracting any depreciation reported previously, from the total of the original cost basis, plus the value of any improvements you've made.
Capital Gain: "Realized Gain" and "Recognized Gain" are the two types of gain found in exchange transactions. Realized Gain reflects the difference between the total consideration or total value received for a given property and the adjusted basis.
Recognized Gain reflects that portion of the Realized Gain, which is ultimately taxable. The difference between realized and recognized gain exists because not all realized gain is ultimately determined to be taxable and issues such as boot can affect how and when gain is recognized.
Net Sales Price: This figure simply represents the sales price, less costs of sale.
Net Purchase Price: This figure simply represents the purchase price, less costs of purchase.
Boot: When considering an exchange of real property, the receipt of any consideration other than real property is determined to be "boot". So, essentially, a working definition of boot is: any property received which is not considered like-kind. And remember, non like-kind property in an exchange is taxable. Therefore, boot is taxable.
There are two types of boot, which can occur, in any given exchange. They are mortgage boot and cash boot. Mortgage boot typically reflects the difference in mortgage debt, which can arise, between the exchange of relinquished property and the replacement property.
As a general rule, the debt on the replacement property has to be equal to, or greater than, the debt on the relinquished or exchange property. If it is less, you'll have what is called "overhanging debt" and the difference will be taxable.
Let's assume for example that you are selling your relinquished property for $375,000 and that it has a mortgage of $250,000. At closing, the mortgage will be paid off and the balance of $125,000 will be held by your facilitator.
Suppose that you then find a new property costing $350,000, with a mortgage of $225,000 that you will assume. The assumption of this debt, along with your exchange trust fund of $125,000 will complete your purchase. Under this example you would have to pay tax on $25,000 of capital gains because your debt decreased by that amount.
Lik>ewise, cash boot reflects the amount of cash or other value received.
New Adjusted Basis: This figure reflects the necessary adjustments to your basis after the replacement property is acquired. Since the amount of deferred gain must be considered, the calculation to determine the new adjusted basis on the replacement property is the purchase price less the amount of gain deferred..
To ensure compliance with requirements imposed by the IRS, we inform you that the information posted provided here does not contain anything that is intended as legal or tax advice, and that nothing herein can be relied upon as legal or tax advice. Further, the IRS wants us to let you know that nothing herein can be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein. In assisting with your Section 1031 tax-deferred exchange, we cannot advise the owner concerning specific tax consequences or the advisability of a tax-deferred exchange for tax purposes. We recommend that anyone contemplating an exchange seek the advice of an accountant and/or attorney.