1031 EXCHANGE DICTIONARY PART 1
The 1031 Exchange Dictionary contains the words and definitions that you must know, even before you even start reading about the Section 1031 Exchange.
Think of this as the language of the deal.
The words and terms are arranged in alphabetical order (with numbers first, of course).
1031 EXCHANGE RULES
A common misconception about the Section 1031 Like Kind Exchange is that there is actually a list of Rules somewhere, that the IRS has provided.
And that you can read and follow, in order to guarantee that you do not mess up.
Not true. There are no Rules written down anywhere on the IRS website.
But there are Rules. And that is why you need a 1031 Exchange Dictionary.
The 1031 Exchange Rules are unwritten, but are still very authoritative because they come from the portions of the language in the Section 1031 Like Kind Exchange statute that is easy enough to understand as written. They also come from interpretation of the law from the cases in the U.S. Tax Court, and the U.S. District Courts. This is where disputes have been settled and those decisions have become what we refer to as the Rules.
In addition, the IRS has written what are known as Revenue Rulings and Private Letter Rulings, and released them to the public, as well as countless advisories and memos.
The 1031 Exchange is one of the very few important matters for which the IRS has never even written an IRS Publication, there is only this advisory, which is old and not much help.
This 1031 Exchange Dictionary that you are now reading is probably the most authoritative reference you could have on the subject.
1031 EXCHANGE TIMELINE
The IRS has a lot of deadlines.
But for about 90% of them, you can get permission to extend the deadline. If fact, for most deadline extensions you don’t have to be given permission, it is automatic if you file the correct “application for extension.” They are never denied, and in fact, never even looked at.
However, there are a few deadlines that the IRS considers absolute. You miss the deadline and you are penalized immediately. There is no request for reconsideration. In fact, there is no department that is even permitted to accept an application for reconsideration. It’s over.
Section 1031 Exchange deadlines are like this.
But they are called timelines. Same thing.
There are two such timelines for the Section 1031 Like Kind Exchange.
The first timeline is the 180 days in which you must acquire a Replacement Property after selling your Relinquished Property.
See details in the 1031 Exchange Dictionary below.
The second timeline is the 45 days in which you must identify to your Qualified Intermediary in writing, a list of properties. This list must include the property that you will end up purchasing as your Replacement Property.
Those details are also below.
In addition to the 180-day and the 45-day timelines, the IRS has other timelines, some of which are clear and some of which are implied.
The clear ones are contained in the Revenue Rulings, and the decisions of Court cases.
The other ones, subject to debate, mostly because of the lack of expert knowledge, are things like how long you must own property, and how soon you can refinance property involved in a 1031 Exchange.
I have discussed those as well.
As I said, there are two Time Periods that begin to run as soon as you sell your Relinquished Property, the 180-day period and the 45-day period.
The 180-day Rule says that within 180 days from the Exchange Date, which is the date on which you sell the Relinquished Property, you must close on the purchase of the Replacement Property.
The second of the two Time Periods that start to run immediately when you sell your Relinquished Property is the 45-day Rule.
This rule says that within 45-days from the Exchange Date, the date on which you sell your Relinquished Property, you must identify to your Qualified Intermediary, in writing, the possible properties that you will purchase as a Replacement Property.
See 1031 Exchange Rules for more details about these two time limits.
There are two types of Depreciation: straight-line depreciation and accelerated depreciation.
I cover the information elsewhere in the 1031 Exchange Dictionary.
And your investment real estate will be made up of both real estate, which is the land and the building, and what the IRS calls tangible personal property, the appliances, etc.
The land cannot be depreciated, but the building can be depreciated, and it will be straight-line depreciation, which means taking an equal amount each year for the life of the property.
But, accelerated depreciation is available for the part of your investment property that is made up of personal property. This is not separate personal property on which you did a Section 1031 Exchange. That is no longer allowed since passage of the Tax Cuts And Jobs Act.
The personal property that you can depreciate is the personal property that is part of your investment property, but is not categorized as real estate, it is categorized as personal property because it has a shorter depreciation period, 20 years or less.
Accelerated depreciation means that you will be able, for example, to deduct each year more than ten percent (10%) of the book value of an asset with a ten-year life, instead of only 10% each year as you would with straight-line depreciation.
There are four types of accelerated depreciation, but the most popular is called Double Declining Balance, or DDB.
With this method, in the first year, you would deduct twenty percent (20%) of the book value of an asset with a ten-year life, instead of the normal 10% for straight-line depreciation.
For a $10,000 asset you could deduct $2,000 for the first year.
It gets tricky in the second year.
After the first year, the book value of a $10,000 asset has declined to $8,000 at the beginning of the second year, because you just deducted $2,000 in Depreciation.
So, now you can deduct 20% of $8,000 = $1,600.
Third year: 20% of $6,400, etc.
Alternatively, you would be able to use Bonus Depreciation if you choose.
And if you would like a thought-provoking article about whether you actually receive anything of value with Depreciation, I have another Article that I recommend, Depreciation Is A Fraud. It will open in a separate tab and you can read it later.
Your “basis” in your property is what you paid for it, plus any capital improvements you have made.
Your “adjusted basis” in your property is your basis in the property adjusted for the depreciation that you have taken. In other words, total costs less the depreciation deduction.
It is also referred to as “depreciated basis,” or “book value.”
There are other situations which might result in an adjusted basis, such as a casualty loss (fire) for which you were reimbursed by insurance.
In this case you subtract the amount of the insurance from your basis, and this is your adjusted basis.
But in most cases, the adjusted basis is the result of depreciation taken.
ASSIGNMENT OF BENEFITS
One of the 1031 Exchange Rules is that you are not allowed to receive, or have any control over, the Net Sales Proceeds when you sell your Relinquished Property.
Therefore, you must make sure that the proceeds go to an independent third party, called a Qualified Intermediary.
Most people writing about 1031 Exchanges say that you do this by assigning the Sales Contract to the Qualified Intermediary. Some Qualified Intermediaries even say that.
It is incorrect.
You do not assign the contract. If you did, the Qualified Intermediary would then be selling the property, and he would be signing a Deed to sell property that he does not own.
You assign the benefits of the contract, in other words, the Net Sales Proceeds from the Closing. You still attend the real estate Closing and sign the documents. The document is called an Assignment of Benefits. The contract still closes in your name.
ASSUMPTION OF DEBT
This goes beyond my intended purpose for the 1031 Exchange Dictionary, but I will mention a financing question that I often get.
And Yes, you can sell your Relinquished Property, and instead of having the debt on the property paid off at Closing, using some of the Sales Proceeds, you can have the Buyer assume that indebtedness.
But if you do, there are two problems.
The first problem is that the debt assumption is considered “boot” and will be taxable to you, unless you assume an equal amount of debt on the Replacement Property which you buy. Then you “net the boot” and it cancels out.
The second problem involves your Lender.
If you do this, you will probably not be released from primary responsibility on the loan even if your Lender allows the new owner to assume the note, and you could end up having to pay it if, say, the property burned and the new owner had not kept the insurance policy current, or the Lender held you responsible in some other way.
Also, if you assume debt on the Replacement Property, this debt will be secured by a first lien on the Replacement Property in favor of the existing Lender, the debt which you are assuming. When you go to your own Lender to borrow the additional amount you need for the purchase, your Lender will probably refuse to make the loan secured by a second lien. And of course, he can’t get a first lien because there is already a first lien on the property.
The 1031 Exchange Dictionary can only take you so far in understanding this. You should explore the appropriate tabs at S1031Exchange.com to get a deeper understanding.
The basis in your property is the amount that you paid for the property when you bought it, plus any capital improvements made to the property.
If you have claimed depreciation on the property, then your basis become “depreciated basis.”
This is the amount that you paid for the property, plus any capital improvements made to the property, minus any depreciation allowed (even if you did not claim it on your tax return.)
You can walk through the steps and see exactly how this works at Capital Gains Tax.
Certain new and used business property that qualifies for depreciation, is also eligible to be claimed as an additional deduction for a percentage of the purchase price for the first year that it is placed in service, even up to 100%.
This is referred to as bonus depreciation.
It is covered by Section 179 of the Internal Revenue Code (IRC), and is also referred to as Section 179 deduction or depreciation.
There are additional sections of the IRC that provide for other types of bonus depreciation, and they are too many to cover here.
Boot is anything that you receive for the sale of your Relinquished Property other than cash that is not “like kind” property.
It could be cash, but it could also be debt assumption, or a promissory note, or a motor home, or a boat; really, anything of value.
It could also be proceeds from a refinancing of the property that you did in anticipation of the exchange without an independent business purpose, which is not allowed.
You can read all about the dangers of that at Refinance.
There are four types of 1031 Exchanges.
Simultaneous, Delayed, Reverse, Construction.
In a Reverse Exchange, the Exchangor wants to buy his Replacement Property immediately, before he will have time to sell his Relinquished Property like he would in a normal Delayed Exchange.
Since he cannot own both properties at the same time, he must use an Exchange Accommodation Titleholder (EAT) to hold title to one of them temporarily.
He has two routes he can go, either “Buy First” or “Sell First.”
If he chooses Buy First, his EAT will acquire title to the Replacement Property and hold it until the Exchangor has sold his Relinquished Property, and then transfer the Replacement Property to him.
Read later about “Sell First.”
The Buyer is not the person engaging in the Section 1031 Like Kind Exchange. This is not you.
The Buyer is the person who buys the Relinquished Property from the Exchangor, which is you.
The could be anyone.
He has no control over whether the Exchangor will be able to qualify for a Section 1031 Like Kind Exchange.
Provided the Buyer is not a Related Person, it does not matter what the Buyer does with the property that he buys from the Exchangor.
All he has to do it bring the money.
CAPITAL GAINS TAX
The IRS considers everything that you own to be a Capital Asset, and when you sell a capital asset, you will either have a Profit or a Loss.
A Profit is called a Capital Gain, and it is classified as Income, and there will be a tax assessed.
This is called a Capital Gains Tax.
The tax brackets for Capital Gains are 0%, 15%, and 20%. They are not the same as your personal tax bracket for your Ordinary Income.
If you have a loss, you will incur a Capital Loss. This loss might be used to reduce your other income, under some specific set of circumstances.
The way your Profit or Loss is computed is by taking your sales price and subtracting your basis in the property.
Your Basis is what you paid for the property, plus any capital improvements, and minus your allowed depreciation. This Basis is also called your Depreciated Basis.
CAPITAL GAINS TAX RATE
The capital gains tax rate is the rate you will pay for the tax on your capital gains when you sell your investment property.
There is a 0% tax rate, 15% tax rate, and a 20% tax rate.
It is not the same as your personal tax rate for your other Earned Income, called the Ordinary Income Tax Rate.
The rate that applies to you will depend on the amount of your other taxable income for the tax year.
When you have a capital asset, regardless of whether or not it is producing income, you will sometimes make improvements to it, such as adding a garage to a Duplex that you are renting out.
This garage is an example of a Capital Improvement.
The garage and the amount that you spent on it must be placed on your Depreciation Schedule, and a specific allowed amount is deducted from your taxable income from the asset each year.
If the property is producing no income from which the Depreciation Allowance can be deducted, the amount spent on the Capital Improvement is added to your basis in the property, and when you sell the property, it is deducted from the sales proceeds in order to determine your Capital Gains.
As previously mentioned, a Construction Exchange is a type of Section 1031 Like Kind Exchange.
It is just one of the four types.
The others are a Simultaneous Exchange, Delayed Exchange, and Reverse Exchange.
A Construction Exchange is also referred to as a Build To Suit Exchange, and as an Improvement Exchange.
A Construction Exchange is used by someone who wants to buy property and rehab it as his Replacement Property.
However, if he just bought it first, the Section 1031 Exchange would be over at that point, before he could do the rehab.
So, the process is that his Qualified Intermediary sets up an LLC called an Exchange Accommodation Titleholder (EAT) to purchase the property and lease it to him and he does the work and then buys the property.
CONSTRUCTION IS COMPLETE
This is a phrase instead of a word, but still needs to be in the 1031 Exchange Dictionary.
“Construction is complete” is a term used in reference to a Construction Exchange.
A Construction Exchange is where you want to buy a property and do construction improvements, or a situation where you want to buy a piece of real estate and build a structure on it, but you want the property that you buy to be your Replacement Property in a Section 1031 Exchange.
The problem is that if you sell your current property and then buy this property or this piece of real estate as your Replacement Property, the Exchange is over at that point. You can’t continue to spend the Net Sales Proceeds on the construction, because they have been distributed to you at Closing and have become taxable.
So you will have your Qualified Intermediary set up an entity called an Exchange Accommodation Titleholder (EAT), usually a business entity in the form of a Limited Liability Company (LLC), to buy the property and lease it to you so that you can do the rehab or construction, and when you’ve finished, the EAT will sell the property to you, after you have sold your Relinquished Property.
You will have 180 days from the date the EAT acquires the property to complete the job, and if you do, at the time of closing, the “construction is complete.”
But you can miss the 180-day deadline without creating a disaster. Even if you don’t get the work done on time, under some conditions, you can still finish the Section 1031 Exchange and defer most of the capital gains tax.
See the next definition.
CONSTRUCTION IS NOT COMPLETE
See the previous definition for background.
Now, if you did not get all of the work done by the end of the 180 day period, if “construction is not complete,” you can close on the Section 1031 Exchange, but with some computation.
The explanation is very long, and you should got to S1031Exchang.com/construction-exchange/ to read about the specific steps involved and how the numbers will be determined.
This is one of the least-understood concepts in the world of Real Estate Investing.
A complete explanation is beyond the scope of this 1031 Exchange Dictionary, but I do have a comprehensive discussion that I know you will like at Dealer Property.
Well, that’s Part 1 of the 1031 Exchange Dictionary.
The following two Articles will contain Part 2 and Part 3, and I urge you to take a look at them.
DISCLAIMER: I am an Attorney licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. But I am not your Attorney. I would be honored if I were, but I am not. Reading this Article does not create an attorney-client relationship between us. Internet content should not be used as a substitute for the advice of a competent Attorney admitted or authorized to practice law in your state or jurisdiction.
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