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1031 Information and FAQ

Starker or Like-Kind Exchanges

Starker or Like-Kind Exchanges refer to Section 1031 of the Internal Revenue Code whereby the IRS enables the real estate owner to dispose of one investment property and acquire another "like-kind" property without having to pay any capital gains tax on the transaction. "Like-Kind" refers to property which is held for productive use in investment, business or trade. Any property which is held for this purpose and is not seller's/buyer's primary residence is eligible for exchange without any gain or loss recognition by the IRS. Such properties can include commercial real estate, rental property, bare land, apartment buildings, etc. Residential property may be exchanged for commercial property as long as it is not a personal residence. Foreign real estate may be exchanged for other foreign real estate (it is Like-Kind), but it is NOT Like-Kind with U.S. real estate.

Primary Requirements to Maintain Tax-Free status are:

  • Timeline - identification of one or more (up to three) replacement properties must take place within 45 days of the sale of the relinquished property. Any property identified after the expiration of the 45 day timeframe will NOT qualify as an exchange property in this exchange.
  • Intermediary - investor must NOT DIRECTLY RECEIVE any of the proceeds from the sale. IRS regulations require a Qualified Intermediary to properly complete an exchange. Neither the investor's accountant nor his/her attorney can serve as a Qualified Intermediary. The majority of Qualified Intermediaries are affiliated with banks, trust companies or title companies.

The Qualified Intermediary "safe harbors" an exchange, by taking an assignment of rights in the sales contract for the old property and the purchase contract for the new property. Once the attorney assigns the QI to the sales and purchase contracts and completes the exchange agreement, the transaction can qualify as an exchange rather than a taxable sale, subject to compliance with the timing rules. In this manner, the Qualified Intermediary fulfills his most important role which is to hold the proceeds of the sale pending reinvestment in the exchange property. The IRS position is that if the seller receives the proceeds of the sale, then he should be taxed on those proceeds. By using the QI, the seller never receives the cash.

  • The identification and purchase of the replacement property must be completed within 180 days of the sale of the relinquished property. There are NO extensions for any reason.
  • Number of properties identified - the Exchangor may identify up to three replacement properties. He may identify more than three replacement properties if their combined fair market value does not exceed 200% of the value of the property being disposed of.

Basic rules for completing the tax deferral

  • Investor must receive only like-kind replacement property
  • Investor must use ALL proceeds from the relinquished property for purchasing the replacement property
  • The debt on the replacement property must be equal to or greater than the debt on the relinquished property. A reduction in debt can be offset with additional cash; however, a reduction in equity cannot be offset by increasing debt. In short, the rule is to exchange even or up in value; exchange even or up in equity and in debt.

Boot

Should the investor fail to use all proceeds from the relinquished property for the purchase of the replacement property, or should he fail to exchange even or up in equity and debt, he shall be considered to have received non-qualifying property in his exchange. This non-qualifying property is termed "boot." If "boot" is received, then tax is computed on the amount of boot received or the amount of gain on the sale - whichever is lower.

Getting Equity Out and Avoiding Boot

Since the investor must trade even or up, the only way in which to get equity out of a trade and take cash is to leverage up the old property in advance of sale or complete the trade and then refinance the property and take cash out.

Types of Exchanges

  • Delayed Exchange - also known as the Starker exchange. This begins upon close-of-escrow of the relinquished property. From the closing date, seller will have a maximum of 45 days to identify up to three potential properties into which he wishes to exchange. After the 45-day period, the code extends an additional 135 days to complete the purchase on one or all three of those properties identified. The total timeline from the close-of escrow on investor's sold (downleg) property to the close of escrow on his new exchange property (upleg) is 180 days.
  • Simultaneous Exchange - investor may consider a Simultaneous Exchange when he has already identified a property or properties for exchange prior to the closing of escrow of the relinquished property. The two properties will then be exchanged concurrently. Due to the possibility of risks or complications in the timing, investors use a Qualified Intermediary for assistance. In this way, the investor avoids the possibility of having his exchange disallowed due to his having unrestricted control (constructive receipt) of the proceeds from the property sold.
  • Improvement Exchange/Build-to-Suit - pertains to investors who wish to make improvements to the replacement property and have the cost of the improvement included in the exchange value of the replacement property. Such improvement may consist of repairs or remodeling of an existing building, or the construction of a new building on raw land. Please note that all improvements must be completed and the exchange estate dispersed within the 180-day timeline. As a result, Improvement/Build-to-Suit exchanges must allow for certain uncalculated risks which may arise. Therefore, advance planning is critical.
  • Reverse Exchange - this offers advantages for investors who find a replacement property before they sell the investment property. This legal procedure was expanded upon and new revenue procedures were added in October 2000. However, regulations are somewhat vague so this type of exchange can be tricky. The Qualified Intermediary will assist by acquiring title to the new property allowing enough time for the old one to close and hold that property until the Exchangor is ready to make the exchange.

Golden Rules of "Like-Kind" Exchanges

  • DO NOT try to do a 1031 exchange yourself using your CPA or attorney to hold title or funds. IRS regulations require a Qualified Intermediary to properly complete an exchange.
  • DO NOT dissolve partnerships or change the manner of holding title during the exchange. A change in the Exchangor's legal relationship with the property may jeopardize the exchange.
  • DO attempt to sell before your purchase. Occasionally Exchangors find the ideal replacement property before a buyer is found for the relinquished property. If this situation occurs, a "reverse" exchange may be necessary. The IRS allows a reverse exchange if the investor enters into a written Qualified Exchange Accommodation Arrangement ("QEAA"), and engages the services of an exchange accommodation titleholder ("EAT") which is typically a qualified intermediary.

Tenants-in-Common Properties (TIC)

The investment in a Tenants-in-Common property is an alternative to sole ownership of real estate. Also known as co-tenancy, the tenants-in-common structure allows multiple investors to own fractional interest in a single, large commercial property. The investors are not limited partners, or an entity, but individual owners, each receiving an individual deed at closing for his or her undivided percentage interest in the entire property. Each owner has the same rights that a single owner would enjoy - i.e. he may sell or deed his portion of ownership just as he would with his 100% single ownership properties.

TIC properties offer unique advantages for the exchanger as their structure

  • Gives average investor access to investment grade tenants who are generally only available to institutional investors.
  • Provides investor with secure monthly income due to quality of tenant.
  • Provides investor with stability and growth due to quality of tenant.
  • Provides investor with passive income and eliminates management burdens as property management is 'in place'.
  • Enables ownership at modest minimum investment generally starting at investment levels of $250,000 or less whereas 100% single ownership of investment grade tenants typically begins at $1,000,000.
  • Provides a manageable means to diversification & security as TIC ownership enables smaller investor to acquire ownership interest in several properties rather than just one. Investor has access to stable tenants, diversification and a wider range of investment choices.
  • Provides security to the investor through FLEXIBILITY. If an investor identifies a TIC property as one of his replacement choices, he may apply his entire proceeds to the TIC property should his other properties fail. And, if there is investment money left unspent once another property closes, the Exchangor can invest the remaining money in the TIC property.
  • Provides additional protection against tax risk as the Exchangor's investment level in a TIC property can be reserved for a period of time after the identification period thereby decreasing the potential for having to pay a capital gains tax as a result of a failed deal.
  • Facilitates expediency by already having non-recourse financing in place which can be assumed without qualification or loan assumption fees. As TIC properties may not be encumbered in any way, the lender assumes a portion of the borrower's rent proceeds as repayment.
  • Offers liquidity. New investors can select seasoned properties and existing owners can liquidate their partial ownership interest by maintaining a secondary market of TIC ownership interest. Many TIC properties have first right of refusal provisions for their co-owners or buy-back provisions from the seller.
  • Epitomizes the term 'passive investment' as owners are not burdened with day-to-day management, but rather simply sit back and receive a monthly check.

Types of TIC Properties

Various types of properties may be structured as tenants-in-common properties. These include single tenant, multi-family, shopping centers and industrial. Again, these are generally investment grade tenants. By structuring these properties as a TIC, the average investor is able to purchase a portion of ownership at a much smaller investment level than if he were purchasing it as a 100% ownership property.