It’s almost impossible to cover every issue that could come up in a 1031 Exchange. Below, however, are some of the most common issues that need to be considered when exchanging real property:
Seller Financing “Carryback Notes”: If Exchangor is helping the buyer of the Relinquished Property acquire the property, the seller carryback note must be assigned to the Qualified Intermediary and replaced with cash prior to the acquisition of the Replacement Property, otherwise the note may be taxable.
Same Taxpayer Requirement: The same taxpayer who sells the Relinquished Property must acquire the Replacement Property. Example, if a partnership owns and is paying taxes on the Relinquished Property prior, the same partnership must own and pay taxes on the Replacement Property after acquisition.
Related Party Transactions: If related parties are in any way involved in purchasing the Relinquished Property or selling the Replacement Property, the exchange may be disallowed. The IRS has strict related party rules, so please consult with a tax advisor before proceeding with a related party exchange.
Combo Sales and Exchanges: If the Relinquished Property was at any time used in part, or in whole, for both personal use and investment use, both Section 121 (the Homeowner’s Exemption) and Section 1031 may be applicable. We suggest the Exchangor discuss this with their tax advisor prior to the close of escrow.
Identification Period: All Replacement Property must be identified in writing by Exchangor no later than 45 days after the close of the Relinquished Property. It is strictly Exchangor’s obligation to properly identify.
Replacement Property Improvements: Improvements made to the Replacement Property after Exchangor acquisition will not count towards the value of the exchange. If Exchangor would like to make improvements to the Replacement Property using exchange proceeds, a special “Construction Exchange” will be required and a Qualified Exchange Accommodation Agreement (the “QEAA”) must be entered into. If Exchangor wishes to perform a Construction Exchange, it should inform Qualified Intermediary in writing as soon as possible, and no less than 14 days prior to the closing of the Replacement Property. Please also note that Construction Exchanges are not possible on all transactions.
Closing Costs: Non-recurring closing costs related to the sale and purchase of exchange property may be considered exchange expenses that can be paid for using tax-deferred Exchange Consideration.
Tax Deferral: In order to fully defer taxes, clients must re-invest all of the equity “cash” proceeds from the sale of the Relinquished Property into the Replacement Property AND purchase Replacement Property that is equal or greater in value to the Relinquished Property that was sold. Any reduction in value from Relinquished Property to Replacement Property, or any receipt of Exchange Consideration by Exchangor will be subject to tax, dollar for dollar. Tax deferral is not pro-rated.
Earnest Money Contract Deposits: It is recommended that earnest money deposits for replacement property be made with cash out of pocket. Exchangor can then request a refund from exchange proceeds at the close of escrow. If client would like to place a deposit using exchange proceeds, written notice should be given to the qualified intermediary with two business day advanced notice.
Tax Reporting: Individual tax returns for the tax year in which the Relinquished Property must not be filed until all the Replacement Property is acquired and exchange complete. Deadline extensions may be required.
No Legal or Accounting Advice: Federal and state law prohibit qualified intermediaries from providing legal or accounting advice. You must not rely on the qualified intermediary for tax advice.
Written by Leonard Spoto
Owner, Asset Exchange Company
Published on September 8, 2016