These 8 Steps Help Guarantee Success in Your 1031 Tax Deferrment Exchange:
1) Success in doing 1031 property exchanges is mostly about doing exactly the right thing at exactly the right time. Consult with your tax and financial advisors about 1031 rules to determine if a 1031 tax-deferred exchange is appropriate for your circumstances and compatible with your investment goals.
2) Listing the Relinquished Property with a real estate broker. The Exhanger will list the Relinquished Property with a real estate broker. The broker/agent, ideally skilled in 1031 Property exchange functions, will disclose the intent to complete an exchange in the listing agreement.
3) Offer, Counter Offer and Acceptance. The Exchanger (Seller) enters into contract with the Buyer for the sale/exchange of the Relinquished Property that discloses the Seller's intent to complete an exchange, and obtain the Buyer's cooperation.
4) Open escrow for the Relinquished 1031 Property and coordinate with the Facilitator. All earnest money deposits should be placed with the Escrow Company. The Facilitator prepares the property exchange agreement and the necessary amendments and assignments and coordinates with the escrow holder. The close of escrow of the Relinquished Property and the recipe to the net proceeds by the Facilitator completes Phase One of the tax-deferred exchange. Important: The exchange documents must be in place and signed by all parties prior to close of escrow.
5) Identify Replacement Property. The Exchanger must identify all 1031 Replacement Property with 45 days from the close of escrow of the Relinquished Property. The identification must be in writing, signed by the Exchanger, and sent to the proper parties by the end of the 45th day.
6) Contracting for the Replacement property. After closing on the Relinquished Property the Exchanger has up to 180 days to acquire the Replacement Property. With he help of his or her agent the Exchanger enters in to contract to purchase the Replacement Property from the Seller. In the contract to purchase the Exchanger discloses the Exchanger's intent to complete the exchange and obtains the Seller's cooperation.
7) Open escrow for the Replacement Property. The Facilitator prepares the Phase Two Exchange documents and coordinates with the Replacement Property Escrow holder. At the instruction of the Facilitator are placed in escrow and the escrow holder deeds the Replacement Property from the seller directly to the Exchanger. The transaction is closed as Phase Two of a delayed 1031 property exchange.
The REVERSE Exchange
Effective September 15, 2000, the IRS authorized the so-called "reverse starker". You can now arrange to buy a replacement property before you sell your relinquished property, and will still be able to defer any capital gain you have made on the sale of that property.
The new regulations provide specific guidelines on how to accomplish a reverse-Starker exchange. They are complicated, and you must consult your legal and tax advisors before embarking on the 1031 route. Here are some highlights of the new regulations:
- A taxpayer can arrange for the replacement property to be held in a "qualified exchange accommodation arrangement." In government language, this will now be called "QEAA."
- Qualified indicia of ownership of the property by the QEAA is required. This means that the QEAA must either have legal title to the replacement property or other some other arrangement that is acceptable to the IRS to demonstrate ownership. A land sales contract (also called "contract for deed" ) will also suffice. Under this latter arrangement, the QEAA will not have actual legal title, but will have certain obligations under a contract. This will avoid having to pay a double recordation-transfer tax, when the property is first transferred to the QEAA and then to the ultimate taxpayer.
- No later than five business days after the property is transferred to the QEAA, the taxpayer and the exchange accommodation titleholder must enter into a written agreement which provides that the latter is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031.
- Both the taxpayer and the exchange accommodation titleholder (the QEAA) must report the federal income tax attributes of the property on their own federal income tax returns.
- No later than 45 days after the replacement property is transferred, the taxpayer must identify the relinquished property. The IRS allows the taxpayer to identify alternative and multiple properties, and if you have more than one investment property this gives the taxpayer some flexibility as to which property will be sold.
- No later than 180 days after the replacement property is transferred, it must be conveyed to the taxpayer.
- Perhaps the most important aspect of the new reverse Starker regulations is the requirement that the taxpayer have a bona fide intent to engage in a 1031 exchange. According to the new regulations: At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that the property held by the exchange accommodation titleholder represents ... replacement property ... in an exchange that is intended to qualify for non-recognition of gain (in whole or in part) or loss under §1031. This is, indeed, a very complicated area of real estate law. But it does provide one method of deferring the gains made on investment property.
You have also highlighted a very interesting loophole in the law. You want to obtain the replacement property, use it for a couple of years as an investment, and then move into it. Let's look further at this example. Many years ago, you purchased a house for $50,000. You lived in it for several years, but when your family grew, you moved out and started to rent the property. It has been rented since that time. You have made no improvements and it is now worth $500,000.
If you were to sell the property, without engaging in a Starker exchange, your gain (excluding real estate commissions and closing costs for this discussion) would be $450,000. Your federal tax consequences at the current 20 percent rate would be $90,000 ($500,000 - $50,000 x 20%).
Instead of paying this tax, you engage in a 1031 exchange -- either a regular or a reverse Starker. There is no magic formula for how long you have to keep this property rental; the consensus among tax experts is that you should keep the property rented for at least one full year.
After the year is over, you decide to move into the home and treat it as your principal residence. Under other provisions of the tax laws, if you live in this property for at least two years, you can exclude up to $500,000 of the gain (or $250,000 if you a not married or file a separate tax return).
Thus, let's say you eventually want to retire to Florida. You enter into a Starker (or reverse) exchange with your current property and obtain the replacement property down South. Rent it out for at least one year, and then move into it as your principal residence. As long as you play by all of the rules, you may be able to shelter all (or a good portion) of that $90,000 tax which otherwise would have to be paid.