The 1031 Exchange Dictionary is your starting point before you delve into trying to understand the 1031, and you need to understand these words and phrases.
I have previously covered A-C in Part 1, and you can open that now in a separate tab to read it first, or come back to it later.
Deferred Tax just means that, while you do have a tax liability, it is tentative, and the payment is being put off until the occurrence of some future event.
When that event occurs, you will pay the taxes, unless there is another intervening event which changes the picture.
This is the basis of the strategy used in a Section 1031 Like Kind Exchange.
You sell property, and you have a Capital Gains, but you defer payment of the Capital Gains taxes by purchasing a replacement property.
Then you do the same with that new property, and so on.
Taxes are deferred each time.
Then you die. Your basis in the property is “stepped-up” (increased) to the current fair market value when your children, or whoever, inherit it.
Your children sell the property immediately.
They have no capital gains because they sold the property for the same amount as their Basis in the property, which is the stepped-up value that it received when it went through Probate.
Therefore, they do not have to pay the taxes that you have been deferring for your lifetime (or the Depreciation Recapture).
A Delayed Exchange is the most basic of the three types of Section 1031 Like Kind Exchanges.
You sell your current investment property and you have 45 days from the date of sale to make a list of the possible properties you will purchase as a replacement property.
Then you have 180 days from the date of sale to close on the replacement property.
Both timelines are covered elsewhere in the 1031 Exchange Dictionary.
A full explanation of Depreciation is beyond the scope of the 1031 Exchange Dictionary, but the basic concept is not.
When you purchase an asset to be used in your income-producing business, you are entitled to a “depreciation allowance” each year to deduct from that income.
If your asset is a rental Duplex, can claim depreciation for 27.5 years.
That means that if you paid $300,000 for it and assigned $25,000 to the value of the land, you can depreciate the $275,000 for the building.
So, for 27.5 years, you can deduct $10,000 each year from the income it produces.
Now the government wants it back.
When you keep the rental property for five years, claiming a total of $50,000 in depreciation, and then sell the Duplex for $375,000 you will have a capital gains of more than $75,000, the difference between what you paid for it and what you sold it for.
You have depreciated the Basis in the property down to $250,000 so your capital gains will be $125,000 instead of $75,000.
But $50,000 of that capital gains will be because of the depreciation you claimed that reduced the Basis, so now the IRS will tax you up to 25% on the first $50,000 of your capital gains, and call it “depreciation recapture.”
If you set up a legal entity, such as a Limited Liability Company (LLC), and you do not want that entity to be treated by the IRS for tax purposes as a separate entity from yourself, you can file a form electing to have the entity existence be disregarded for tax purposes.
There are rules for qualifying to make this election.
It does not affect any other legal aspects of the existence of the entity, such as any limits against personal liability that it might afford, it is just an agreement between you and the IRS that the entity will not be taxed separately, it will be “disregarded” for tax purposes, and you will report the income yourself and be responsible for the taxes.
There are some situations in which you must file a form making the election to be a disregarded entity, and there are some situations in which the IRS will disregard the LLC automatically unless you file the form making an election to opt out of that treatment.
EAT stand for Exchange Accommodation Titleholder.
It is a legal entity that buys the property that you will rehab, or construct, and holds it for you until you sell your current property and finish the work on this property, so that you can defer the capital gains tax with a Section 1031 Like Kind Exchange.
You can read about the EAT in the Construction Exchange article on S1031Exchange.com.
An escrow account is an account, usually a bank account, held by one entity which contains funds that are owned by another entity.
For instance, a bank will have an escrow account into which it puts part of your loan payment each month, and then uses the money to pay the property taxes at the end of the year, and then starts accruing funds again.
In a Section 1031 Exchange, when you sell your Relinquished Property, the Net Sales Proceeds are sent to your Qualified Intermediary to be held in an escrow account until you are ready to purchase your Replacement Property.
This is an area of major concern to real estate investors, and I cover the two types of accounts in Part 3, as Qualified Escrow Account and Qualified Trust Account, that you should insist on being used by your Qualified Intermediary.
This is the date on which the Exchangor transfers the Relinquished Property to the Buyer in a Delayed Exchange.
In a Reverse Exchange, the Exchange Date is the date on which the EAT acquires the Replacement Property.
In a Construction Exchange, it is also the date on which the EAT acquires the property that will become the Replacement Property.
The Exchange Date is critical because it is the date on which the 45-day Time Period for identifying the Replacement Property begins to run.
It is also the date on which the 180-day Time Period for closing on the second half of the Exchange starts to run.
The Exchangor is the person selling the Relinquished Property and buying the Replacement Property in a Section 1031 Exchange.
That is probably you.
The Exchangor can be an individual, a corporation, a partnership, an LLC, or a Trust.
Look elsewhere in the Dictionary for definitions of these entities.
This is the form that you use to report your Section 1031 Like Kind Exchange to the IRS.
It is a very difficult form to complete and I have a complete explanation of what is involved at Form 8824.
There is no “statutory holding period” for either your Relinquished Property or your Replacement Property.
That means that there is not a written law or section of the law that spells it all out.
But that does not mean that there is not a required holding period for the two properties.
For your Relinquished Property, you must have held it for at least a year and a day in order for the gain on the sale to qualify as Long Term Capital Gains.
Section 1031 is about deferring taxes on Long Term Capital Gains.
For your Replacement Property, the requirement is that it is “to be held for productive use in a trade or business or for investment” at the time that you buy it.
The IRS has expressed their position that the property must then additionally be held for at least a year, and preferably more, in order to show that it is being held for productive use in a trade or business or for investment. Just saying that is what you intended to do on the day you bought it is not enough.
So, there are holding periods for both Relinquished Property and Replacement Properties.
“HUD” stands for Housing and Urban Development, the government agency.
HUD-1 is a form created by that agency that is used for all real estate closings in the United States, regardless of the state where they take place.
It is identical (almost) everywhere.
When you buy or sell real estate and it involves a title insurance policy, a lender, etc., you will have a HUD-1.
It is also referred to as a Settlement Statement.
And Improvement Exchange is another term for a Construction Exchange, or a Build-to-Suit Exchange, with the “Exchange” being a Section 1031 Like Kind Exchange.
A full explanation of all that can be found at Construction Exchange.
“Intent” is the most misunderstood concept in Real Estate Investing.
You need to look at this.
A full explanation of the situation is at Intent.
The term “investment property” is important because it says what the property is, but also what the property is not.
There are legal requirements.
For the property you are selling, called your Relinquished Property, it must be property that is being “held for productive use in a trade or business or for investment” in order to qualify for a Section 1031 Like Kind Exchange.
It cannot be property that you have bought or developed in order to sell it, as long as it is not part of an “inventory” that you are selling to customers. That would make you a “Dealer” and not qualified to use Section 1031.
After you have sold your Relinquished Property, then your Replacement Property must be property that is “to be held for productive use in a trade or business or for investment.”
That means that you will be renting it out or, if it is raw land, just holding it and waiting for it to go up in value.
You cannot buy Replacement Property and then just sell it for a profit.
But what you must avoid is having either property be classified as “dealer property” and therefore be disqualified from doing a Section 1031 Exchange.
This is critical information and you need to read about it at Dealer Property.
LONG TERM CAPITAL GAINS
Long Term Capital Gains refers to the category of the tax bracket you are in when you sell a capital asset and have a profit.
If you have held the asset, and we are talking about investment income property here, for at least one year and one day, then your holding period is long term, and the tax that you pay on your profit (capital gains) is Long Term Capital Gains tax.
If you have held the capital asset for less than one year and one day, then the holding period is Short Term.
There is also a tax rate for Short Term Capital Gains, usually the same as your Ordinary Income tax rate.
LONG TERM CAPITAL GAINS TAX
The Long Term Capital Gains Tax is the tax that you pay when you have sold a capital asset that you held long term and made a profit.
Long term means at least a year and a day.
Profit means that you sold it for more than your adjusted basis.
Profit is the same as Capital Gains.
The amount of tax due on Long Term Capital Gains depends on your tax bracket, that is, the total amount of your other income for the tax year.
The three brackets for Long Term Capital Gains taxes are 0%, 15%, and 20%.
LIKE KIND EXCHANGE
Your Replacement Property must be “like kind” to the property you are selling, your Relinquished Property.
This can best be explained with examples, so you need to read the section on 1031 Exchange Rules where I have done that.
NET SALES PROCEEDS
Your net sales proceeds are what you would be given at the Closing on the sale of you property if you were not doing a Section 1031 Exchange and purchasing a Replacement Property.
If you are doing a Section 1031, these are funds that must be sent to your Qualified Intermediary so that you will not have control, receipt, or constructive receipt of them, and that your QI will transfer back to the closing agent to be used in purchasing your Replacement Property.
Owner financing is when the seller of the property takes a note and deed of trust on the property instead of receiving cash.
The purchaser will make payments to the owner just like they would be making payments to a bank who loaned them the money to purchase the property.
If the payments are not made as provided in the note, the seller can foreclose on the property under the terms of the deed of trust, just like the bank could do if there was a bank loan.
Owner financing in a Section 1031 Exchange will result in the Exchangor receiving a note instead of cash in exchange for the property, and this will result in taxable boot.
There are ways to avoid the taxes just as though cash were received, and I discuss those techniques elsewhere.
PARTIALLY TAX DEFERRED
A Section 1031 Like Kind Exchange allows you to defer taxes on your capital gains from the sale of your Relinquished Property.
But you can do an exchange in which you receive part of your capital gains proceeds and only defer taxes on the rest of the capital gains.
This is complex, and I have an explanation in 1031 Exchange Rules that includes examples and numbers. Please go there for the best information.
A Section 1031 Exchange can involve two types of property, real property and personal property, handled together as one property.
The real property must be exchanged for like kind real property, and the personal property must be exchanged for like kind personal property.
Personal property is considered any property that is not real property.
This will include items like the furniture in a Duplex, or washing machines in the laundry room of any apartment building.
Almost any real property will be considered like kind to other real property if both are used for the same purpose, but personal property is seldom like kind to the personal property that you are purchasing, and this can be a problem.
But the IRS will allow you to lump the real property and the personal property together under some circumstances, and you treat it all as real property and still qualify for the Section 1031 Exchange.
This is an abbreviation that you will see on your HUD-1 Settlement Statement at closing.
It stands for “Paid Outside Closing.”
It means that there was an item that is part of the transaction that was not paid with the proceeds of the sale, but that one of the parties paid directly to the provider of that product or service.
You should notice this because you might need the dollar amount of the POC in order to compute your capital gains, or your basis, or to complete your Form 8824 reporting the transaction to the IRS.
Well, that’s it for Part 2, and I will complete the 1031 Exchange Dictionary in Part 3.
I touch on these same concepts in more than one of my books, but the one with the most detailed information is “Do This, Not That!” and you can find it here on this website. Use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you will really appreciate the value of what we are talking about, and I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
If you are interested in exploring my Catalog of Real Estate Investing books, but don’t know where to start, I suggest these three.
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