1031 Exchange Dictionary Part 3

The Section 1031 Exchange Dictionary is divided into three parts.

This is the third part.

You must understand these words and terms in order to understand the Section 1031 Like Kind Exchange.  The IRS has used words that don’t have the traditional definitions.

You’ll see what I mean.

PRIMARY RESIDENCE

Your primary residence is where you usually live.

For the definition of primary residence, the IRS has specific language for you to look at, depending on what situation you are dealing with regarding the definition of a primary residence.

For owners of property, your property will be either your primary residence, a second home, or investment property.

Your primary residence does not qualify for Section 1031 Like Kind Exchange.

However, Section 121 of the Internal Revenue Code provides an exemption from taxation for your profit when you sell your primary residence, if you have lived it as your primary residence for at least two of the five years prior to the sale.

The exemption from capital gains tax is up to $250,000 for a single person, and $500,000 for a married couple, filing jointly.

PROPERTY DESCRIPTION

There are two instances when an accurate property description is very important, and an inaccurate one can disqualify your Section 1031 Exchange.

First, when you sell your Relinquished Property, called the Exchange Date, you must identify at least three potential properties that will be purchased as a Replacement Property, and you must do it within 45 days.

You then have 180 days from the Exchange Date to close on your Replacement Property.

In an audit, the IRS can challenge you if you put down some vague descriptions that would allow you to choose from a larger list of properties.

Don’t try that.

You must be specific.

The second instance is when you are doing a Construction Exchange, and you are identifying a Replacement Property that has not even been built yet, so cannot be described except as to what you plan for it to be.

There is a small amount of leeway here, but be as close to your building plans as you can.

You might need to get the help of a Surveyor with this.

PURCHASE PRICE

This is not the price of the new Replacement Property that you are buying, this is the original price paid by you, the Exchangor, for the property that is now becoming the Relinquished Property.

It is necessary to start with this price before identifying any of the other prices, because this price determines the Basis in the Relinquished Property, and that Basis is the beginning of all of the other calculations, such as the determination of Capital Gains, net sales proceeds, etc.

QEAA

QEAA stands for Qualified Exchange Accommodation Agreement.

It is an agreement signed by you and your Exchange Accommodation Titleholder (EAT) when you have an independent third party entity taking title to a property that you will then be acquiring from it.

You should read Reverse Exchange and Construction Exchange to see how this works.

QUALIFIED ESCROW ACCOUNT

In a Section 1031 Like Kind Exchange you will do an Assignment of Benefits of your Sales Contract on your Relinquished Property to your Qualified Intermediary (QI), and your QI will receive your Net Sales Proceeds from the first Closing.

Your QI will hold your funds in a financial account of some type.

You should make sure that the account is held in a bank.

You should make sure that the funds are not comingled with the funds of other parties.

You should make sure that the funds are held in a separate account in the name of the QI with the additional “in trust for” or “as trustee for” and your name and TIN on the “memo” post on the account.

If the QI maintains a master account with sub-accounts, make sure that your sub-account is identified with your name and TIN.

Specify that the account must be a Qualified Escrow Account, and the QI can only withdraw the funds with your consent.

You should have a separate written agreement signed by you and your QI called a “Master Qualified Escrow Account Agreement.”

Read it carefully with an eye toward what happens if your QI goes bankrupt, goes South, or the depository institution doesn’t open up in the morning.

QUALIFIED TRUST ACCOUNT

In a Section 1031 Like Kind Exchange you will do an Assignment of Benefits of your Sales Contract on your Relinquished Property to your Qualified Intermediary, and your QI will receive your net sales proceeds from the first Closing.

Your QI will hold your funds in a financial account of some type.

You should make sure that the account is held in a bank.

You should make sure that the funds are not comingled with the funds of other parties.

You should make sure that the funds are held in a separate account in the name of the QI with the additional “in trust for” or “as trustee for” and your name and TIN on the “memo” post on the account.

If the QI maintains a master account, with sub-accounts, make sure that your sub-account is identified with your name and TIN.

Specify that the account must be a Qualified Trust Account, and the QI can only withdraw the funds with your consent.

You should have a separate written agreement called “Agreement For Qualified Trust Account” signed by you and your QI.

Read it very carefully, with an eye toward what will happen if your QI goes bankrupt, goes South, or the depository institution doesn’t open up in the morning.

QUALIFIED INTERMEDIARY

This is the independent third party that will stand between the Exchangor and all of the parties to the transaction: the Buyer, Seller, Title Company, Real Estate Agent, Contractor, Attorney, Bank, etc.

The purpose of the Qualified Intermediary is to handle the money so that the Exchangor will never touch it or have any control over it, which would disqualify the Section 1031 Like Kind Exchange.

The Qualified Intermediary is paid by the Exchangor to make sure that everything is done in accordance with the Exchange rules and provide documentation for the IRS.

REFINANCE

A taxpayer who wants to take equity out of his Relinquished Property before selling it, or wants to take equity out of the property he acquires as a Replacement Property, will attempt to refinance the property.

That will reduce the amount of the Net Sales Proceeds at Closing that he will be required to reinvest, and will allow him to get the Net Sales Proceeds back after completing the 1031 Exchange.

This will avoid paying taxes, and will increase the cash in his pocket.

Don’t do it.

Both pre-Exchange refinance and post-Exchange refinance will lead to the IRS declaring the loan proceeds to be taxable as “boot” because the refinance is part of a step-transaction, and is the same as a distribution of part of the net sales proceeds at Closing.

However, refinancing is allowed if done a sufficient amount of time before or after the exchange, and is not done “in anticipation of an exchange,” and is done in the normal course of business.

RELATED PERSONS

If you sell your Relinquished Property to a Related Person, or buy your Replacement Property from a Related Person, special rules come into play.

First, a definition: a Related Person means your spouse, your brother, your sister, your child, your grandchild, your parent, or your grandparent.

It also includes a corporation or similar business entity in which you own more than 50% of the stock.

This percentage includes your spouse’s ownership.

The definition of a related person also includes a Partnership and a Limited Liability Company in which you and your spouse own an interest of more than 50%.

It also includes trusts and estates, with complex issues.

Related Persons can do a direct swap of properties, and that transaction will qualify as a Section 1031 Exchange for one or both of them, but each of them must then hold onto their acquired property for a period that is more than two years after the date of the last transfer which was part of the Exchange.

If either person violates this requirement during the 2+-year waiting period, the 1031 Exchange is invalidated, with taxes and interest and penalties assessed, for both of them.

Each person who qualified the transaction as a 1031 Exchange must continue to file Form 8824 for two years following the year of the Exchange.

Also, in addition to a direct swap, the Exchangor can sell the Relinquished Property to a Related Person.

But the Related Person is required to hold the property for the two-year period described above, and failing to do so will invalidate the Section 1031 Exchange for the Exchangor.

And the Exchangor is held to the same requirements of Form 8824 described above, except that it might turn into three years, because the period will start to run from the date he acquires the Replacement Property, which could be as long as 180 days after selling the Relinquished Property.

The only exception to the two-year holding period requirement is in the event of death or other involuntary conversion.

But the real danger in a transaction involving a Related Person is in buying a Replacement Property from a Related Person.  It is not absolutely prohibited, but it guarantees that the IRS will look closely at the transaction.

There is no single “rule” that we can look at to see the IRS position on this, but there are a series of court decisions that make up the position of the IRS.

And if there were a rule, it would say that the IRS just doesn’t like it when one Related Person ends up with the Section 1031 property, and another Related Person ends up with the cash.

RELINQUISHED PROPERTY

This is the property that the Exchangor wants to sell without paying Capital Gains Tax on the profit by using a Section 1031 Like Kind Exchange.

It can be either business property or investment property, or both.

It can be real property with personal property attached or included, but it cannot be just personal property with no real property involved.

Real property must always be exchanged for like kind real property, and if personal property is included with it, the personal property must always be exchanged for like kind personal property.

The property must have been held for at least one year and a day.

It must be property held for productive use in a trade or business or for investment.

REPLACEMENT PROPERTY

This is the like kind property that the Exchangor intends to purchase to replace the Relinquished Property in order to qualify for a Section 1031 Like Kind Exchange and defer the taxes on the Capital Gains.

It can be either business property or investment property, or both.

It can be either real property or real property combined with personal property.

But you must exchange exchange real property for real property, and personal property for personal property.

Personal property alone no longer qualifies for treatment under Section 1031.

It must be property of the type that can be held for investment or for business purposed by the Exchangor.

It does not matter what the current use of the property is, or what the previous use of the property was.

The Replacement Property can be a single property, or it can be multiple properties.

And the Exchangor must take title to the Replacement Property in the same name in which the Relinquished Property was held.

REVERSE EXCHANGE

A Reverse Exchange is when you buy your Replacement Property before you sell your Relinquished Property.

You do a 1031 Exchange, but do it in reverse.

It is permitted, but with stipulations and rules.

Read the entire process at Reverse Exchange.

SAFE HARBOR

There are a number of rules that you must follow if you are doing a Section 1031 Like Kind Exchange.

You will have to retain proof that you have followed these rules in case the IRS ever requests documentation.

However, there are some procedures that you can follow and the IRS will provide you a “Safe Harbor” that your compliance will not be challenged.

There are many Safe Harbors and you will read about them throughout the material here.

SALES PRICE

This is the price for which the Relinquished Property is being sold, and along with the Purchase Price, will determine the Capital Gains, and will probably be a major factor in your consideration of whether to even do a Section 1031 Like Kind Exchange.

SECTION 121 EXCLUSION

The Section 121 exclusion is the exclusion from capital gains taxation that is contained in Section 121 of the Internal Revenue Code.

Section 121 provides an exclusion from taxation on your profit when you sell your primary residence, if you have lived in your home as your primary residence for at least two of the five years prior to the sale.

The amount of the exclusion is $250,000 for a single person, and $500,000 for a married couple filing jointly.

If you occupy your primary residence for two years, and then you move out of your primary residence and rent it out for three years, and then sell it, all within a five-year period, you still qualify for exclusion of taxation on all of the capital gains, but you must pay taxes on the amount of depreciation that you claimed while it was being treated as an income property.  This is called Depreciation Recapture.

SECTION 1031

Internal Revenue Code Section 1001(c) requires that the entire amount of the gain or loss on the sale or exchange of property shall be recognized.

Section 1031(a), however, provides for the nonrecognition of gain or loss when property held for productive use in a trade or business or for investment is exchanged solely for like-kind property that is to be held for productive use in a trade or business or for investment.

SECTION 1250 PROPERTY

Section 1250 property is the property that you own and use as investment property.

It is described in Section 1250 of the Internal Revenue Code.

It can only be depreciated using the straight-line method, with equal amounts claimed for depreciation each year.

If the Section 1250 property is the type classified as Residential Real Estate the period of depreciation is 27.5 year.

If the Section 1250 property is commercial real estate, the period is 39 years.

SELL FIRST

This is one of your two choices in a Reverse Exchange.

It is explained in the Dictionary item called “Buy First,” which I cover in 1031 Exchange Dictionary Part 1.

Please go there.

SELLER

This is the person who owns the property that the Exchangor wants to purchase as his Replacement Property.

Like the Buyer of the Relinquished Property he could be anybody as long as he has the appropriate piece of property to buy, and as long as he is not a Related Person.

He will have nothing to do with determining whether the Exchangor can qualify for a Section 1031 Like Kind Exchange.

However, he must be told that the transaction he is entering into involves a Section 1031 Like Kind Exchange for the Exchangor, and that he will be required to do certain things in cooperation.

If the Replacement Property is comprised of more than one property, there might be more than one Seller.

SELLER FINANCING

Seller Financing is when the seller of the property receives a debt instrument from the buyer instead of cash.

If Seller Financing is involved in your sale of your Relinquished Property, or in the purchase of your Replacement Property, it seriously impacts the Section 1031 Exchange.

SETTLEMENT STATEMENT

See HUD-1 in Part 1.

TAX DEFERRED

This is the same as Deferred Tax, see Part 1.

TENANTS IN COMMON

Tenants in common are two or more individuals owning real estate as a tenancy in common.

It does not mean that they are tenants and live in the property.

A tenancy in common is a shared tenancy in which each holder had a distinct, transferrable interest in the ownership.

If you and your brother own ten acres of land as tenants in common you will each own an interest equal to fifty percent, because there are two owners.

The interest is an undivided interest.

That means that you cannot select five acres and claim it.

You own fifty percent of every 1/100 of a square inch of the entire ten acres.

You each have equal right to the use and possession of the entire ten acres.

Your interest is freely transferable, by deed or by Will.

TIME PERIODS

There are two critical time periods in a Section 1031 Like Kind Exchange.

One is a 45-day period, and the other is a 180-day period.

You can read about both in Part 1, the first two items in the 1031 Exchange Dictionary.

TITLE COMPANY

Real estate transactions are handled differently in different parts of the country.  In some states, an Escrow Company handles everything.

In some states only Attorneys are authorized to handle real estate closings.

And in some states, the State has licensed a Title Company to handle real estate closings and insure title to the property.

TRANSFERRED BASIS

When you sell a Relinquished Property, you will have a basis in it, which you can read about in Basis in Part 1.

That basis will become part of the new Replacement Property.

I have a very good explanation, with numbers, on the Capital Gains Tax page.

CONCLUSION

And that concludes the three Parts of the 1031 Exchange Dictionary.

I have a more complete version of this on my other website, S1031Exchange.com/dictionary.

RESOURCES

I touch on this same concept in more than one of my books, but the one with the most detailed information is “How To Do A Section 1031 Like Kind Exchange” 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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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 Blog does not created 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.

April 24, 2022

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