A 1031 Exchange is an IRS-authorized process where like-kind business or investment properties are exchanged without immediate tax liability to the property owner (Exchangor).
The IRS requires that an Exchangor use a neutral third party, known as an intermediary or accommodator, to facilitate a 1031 Tax Free Exchange. Equity Advantage, Inc. is a qualified intermediary agency able to properly assess the current 1031 Exchange rules and assist Exchangors with the process.
The definitions for the following types of exchanges are provided by Equity Advantage. Visit 1031exchange.com to tap a wealth of reference materials regarding exchanges.
The delayed exchange is common and straightforward: the Exchangor relinquishes property before he acquires property. In other words, the property the Exchangor owns (called the “relinquished” property) is transferred first. The property the Exchangor wishes to own (called the “replacement” property) is acquired second.
Before the delayed exchange is initiated, the Exchangor is responsible for marketing his property, securing a buyer, and executing a sale and purchase agreement. The Exchangor’s obligation to sell the relinquished property is then assigned to Equity Advantage. By the assignment, Equity Advantage transfers the relinquished property to the buyer. Equity Advantage then receives money (exchange proceeds) from the buyer for the relinquished property.
Within 45 days of the relinquished property transfer, the Exchangor must identify replacement property to acquire. The Exchangor negotiates the purchase terms for the replacement property with the seller and executes a purchase and sale agreement. The Exchangor’s obligation to buy the Replacement property is then assigned to Equity Advantage. The assignment allows Equity Advantage to use the exchange proceeds (in addition to other funds provided by the Exchangor) to purchase the replacement property.
Equity Advantage is mandated by IRC 1031 to transfer the replacement property to the Exchangor within 180 days of the relinquished property transfer.
The Reverse Exchange is the opposite of the Delayed Exchange. Where the Delayed Exchange requires the Exchangor to relinquish property before he acquires property, the Reverse Exchange allows the Exchangor to acquire property first and relinquish property second. In other words, the Reverse Exchange allows an investor to acquire a new property today, when an excellent investment may be available, and sell other property later when a better price might be obtained.
The Reverse Exchange greatly expands the ability of the investor to take advantage of changes in the marketplace and to improve his or her investment position.
The Reverse Exchange is structured primarily with Revenue Procedure 2000-37 in mind. Although Reverse Exchanges have been structured for decades prior to the Revenue Procedure, many investors now follow the Revenue Procedure to receive the safe harbor benefits.
The Revenue Procedure provides that the IRS will not challenge the qualification of property as either or if there is a qualified exchange accommodation arrangement (QEAA). The requirements of the QEAA are:
- The property is transferred to an exchange accommodation titleholder (EAT). Equity Advantage creates the EAT in the form of a LLC. The purpose of the transfer is so that the taxpayer is not the holder of the property.
- At the time of transfer to the EAT, it is the taxpayer’s intent that the property held by the EAT represents either the replacement and/or relinquished property.
- No later than five business days after the transfer of the property to the EAT, there must be a written Qualified Exchange Accommodation Agreement.
- No later than 45 days after the transfer of the replacement exchange property to the EAT, identification of the relinquished property or properties is required. The identification must be consistent with the existing delayed rules.
- The combined time period that the relinquished and replacement properties are held in the Qualified Exchange Accommodation Agreement is not to exceed 180 days.
Additionally, the Exchangor cannot receive property already owned as replacement for property to be relinquished.
PRACTICAL CONSIDERATIONS FOR THE REVERSE EXCHANGE:
First and foremost the Exchangor needs to have the financial ability to purchase the replacement property. Remember, the Exchangor will not have the benefit of sale/exchange proceeds since the relinquished property has not yet been sold. The Exchangor must draw upon other financial resources for the acquisition. If a loan from a commercial lender is needed, then the lender has to be willing to lend the money to the EAT.Equity Advantage knows of such lenders who can make this accommodation and may provide the information to you.
Parking refers to the EAT taking and holding title to the property during the exchange. (“Warehouse”, “station”, “place” would also be apt descriptions, but the IRS uses “park” as its metaphor.) This parking technique is used because Revenue Procedure 2000-37 prohibits the Exchangor from having ownership of the relinquished and replacement property simultaneously.
There are two parking approaches for completing a Reverse Exchange: park replacement property and park relinquished property. Deciding which property (either the replacement property or relinquished property) is parked is determined by considering a number of factors: the funding source to pay for the acquisition, liens on the relinquished property, and the equity in the relinquished property.
If the Exchangor wishes to improve the replacement property, then the replacement property must be parked. Any improvements are to be constructed prior to the Exchangor’s receipt of the replacement property.
No matter which property is parked, the property is available to the Exchangor. Equity Advantage creates a lease and property management agreement between the EAT and the Exchangor so that the Exchangor has complete access to the parked property.
Park Replacement Property
In the park replacement approach, Equity Advantage creates a new single member LLC in which Equity Advantage is the sole member of and the replacement property is the sole asset.
The new LLC serves as the EAT. The LLC borrows money from the Exchangor (and/or a lender) to acquire title to the replacement property. The LLC retains ownership of the replacement property until a buyer is found for the relinquished property. The sale proceeds go to Equity Advantage when the relinquished property is sold just as they would in a delayed exchange. The sale proceeds are then used to payoff loans incurred by the LLC. Finally, Equity Advantage’s ownership of the replacement property is transferred to the Exchangor completing the exchange.
Park Relinquished Property
In the park relinquish approach, Equity Advantage creates a new single member, single asset LLC. Equity Advantage is the sole member of the LLC and the relinquished property will become its sole asset.
When the LLC acquires the replacement property, the LLC simultaneously swaps it with the Exchangor’s relinquished property. In effect, the LLC has transferred the replacement property to the Exchangor and the LLC has received title to the relinquished property. The relinquished property is owned by the LLC until a buyer is found. At the time of closing, title of the relinquished property will be transferred from the LLC to the buyer and the sale proceeds will go to Equity Advantage as they would in a delayed exchange. The sale proceeds are then used to payoff loans incurred by the LLC, completing the exchange.
An Improvement Exchange allows the investor to construct the “perfect” replacement property in order to acquire precisely what is desired. Improvements can be as simple as repairs to existing structures or as complex as ground-up new construction. The Improvement Exchange opens up many opportunities to the savvy investor, even the possibility of improvements to property already owned.
Improvement Exchange Requirement
1031 Exchange requirements must be applied in the Improvement Exchange. This requirement means that all improvements must be constructed within the 180-day time period. With this time constraint, satisfying the “like-kind” requirement may be challenging. When the Exchangor gives up real property, he needs to receive real property in return. If at the 180-day deadline the Exchangor were to receive only unimproved land with labor and materials to be used in the future, the exchange would not be totally tax-deferred. The labor (services) and materials (personal property) are not like-kind to real property. While escrow holdbacks or pre-payment of labor and materials are natural paths in getting improvements done, they do not qualify for tax deferral. The escrow holdbacks and pre-payment of labor and materials are treated as “boot” and are subject to taxation.
The exchange value requirement (Napkin Test) must also be met in the improvement exchange. When the improvements to the replacement property are completed, the replacement property needs to have the same or greater value than the relinquished property.
The following example illustrates how the improvement exchange would be a viable option.
The Exchangor owns a 20-unit apartment building valued at $1.7 million, with $700,000 in debt on the property and $1 million in equity. The Exchangor wants to acquire a medical office building downtown. The type of building the Exchangor wants is currently not available for sale. Fortunately, there is a property for sale in the desired area that has a small vacant retail building on it that can be improved and expanded for office medical suites. The property is available for $1 million and the Exchangor estimates the improvements will cost $700,000. The Exchangor will finance the improvements with a $700,000 construction loan. The Exchangor estimates the improvements to take 5 months and that the value of the improved medical building, when appraised, will be at least $2 million. In this example, the improvement exchange works. The exchange is completed within 180 days and there is an exchange of like-kind property. The value of the improved replacement property (value, debt and equity) are the same as or greater than the relinquished property.
Personal Property Exchange
While most 1031 exchanges involve real property, personal property may be exchanged as well. Personal property does not mean property used for personal gain because IRC 1031 requires all property, whether real or personal, to be used for business, trade or investment. Personal property refers to the asset’s nature and character. Examples of personal property that are exchanged include (but are not limited to) aircraft, heavy equipment and business assets.
The exchange requirements are the same for both real property and personal property. That said, unlike the broad definition of like-kind property for real property, it becomes more difficult to state when personal property is like-kind to other personal property. The difficulty stems from the many different ways to categorize personal property. Personal property may be characterized as depreciable tangible property, depreciable intangible property or non-depreciable personal property.
Depreciable tangible personal property
Depreciable tangible personal properties are considered like-kind if they are like-class; that is, exchanged properties must be in the same class. The classes are established in tax regulations as General Asset Class and Product Class. If the property may be classified within a General Asset Class, then it may not be re-classified into a Product Class.
Intangible and non-depreciable personal properties
Intangible and non-depreciable personal properties are exchanged for like-kind property (there are no “like-class” guidelines for these types of properties). The nature or character of the rights involved, as well as the nature or character of the underlying property to which the intangible personal property relates, determines whether the property is “like-kind.” Items that fall under intangible and non-depreciable personal property include some patents, forms of software, coprights and trademarks.
General Asset Class
General Asset Classes are set forth in Treasury Regulation 1.1031(a)-2.
There are 13 classes in all. They are:
- Office furniture, fixtures, and equipment (asset class .11)
- Information systems (asset class .12)
- Data handling equipment, except computers (asset .13)
- Airplanes (airframes and engines) except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class .21)
- Automobiles, taxis (asset class.22)
- Buses (asset class.23)
- Light general-purpose trucks (asset class .241)
- Heavy general-purpose trucks (asset class .242)
- Railroad cars and locomotives, except those owned by railroad transportation companies (asset class .25)
- Tractor units for use over-the-road (asset class.26)
- Trailers and trailer-mounted containers (asset class .27)
- Vessels, barges, tugs, and similar water-transportation equipment (asset class .28)
- Industrial steam and electric generation and/or distribution systems (asset class.4)
Product Classes are limited to those found in the North American Industry Classification System (NAICS) as set forth by the United States Government. These codes classify enterprises by their business activity. Although the NAICS classes are numerous, the product classes that involve the manufacturing sector are six-digit codes beginning 31, 32 and 33.
Examples of Product Class
Here are some examples of how a 1031 exchange involving personal property would work.
Example 1. Exchangor would like to exchange an aircraft flight instrument for a flight recorder. Neither of these items falls with an asset class, but they both fall within product class 334511. The two items are like-class and eligible for exchange.
Example 2. Exchangor would like to exchange his fishing tackle and equipment for a sonar fish finder. Neither of these two items falls within an asset class. The fishing tackle and equipment fall within Product class 339920. The sonar fish finder falls within Product class 334511. These two items are not like-class and not eligible for exchange.
Example 3. Exchangor would like to exchange his business airplane (used to transport clients and upper level management to meetings) for a new helicopter engine that will later be used in a helicopter that is currently being manufactured for Exchangor’s business. Both the airplane and the helicopter engine fall with an asset class .21. They are like-class and eligible for exchange.
Example 4. Exchangor would like to exchange his 4-door sedan for a heavy duty SUV/truck. These properties are not like class because the sedan falls within asset class .22 and the heavy duty SUV/truck falls within asset class .241. Because the vehicles fall within an asset class, they cannot be categorized in a product class. These two properties are not eligible for exchange.
The blended exchange refers to combining different exchange formats (delayed, reverse and improvement) into one exchange. This approach allows for further 1031 Exchange flexibility, particularly when more than two properties are involved in the exchange.