What You Need to Know to Teach a One Hour 1031 Exchange Class

The 1031 Exchange area is so broad that you could spend days teaching the details of the topic. Most of you, however, want to simply introduce the topic to your students, and you should be able to do that adequately in about an hour. This article gives you an outline and the basic concepts that will let you do just that.

The concept of a 1031 exchange is fairly simple: the gain from the sale of the Old Property rolls over to the New Property. As long as you continue to do 1031 exchanges on each successive property, the accumulated tax is postponed, until you ultimately decide it's time to liquidate your investments. While the correct technical terms are "relinquished property" and "replacement property," I always use the terms "Old Property" and "New Property" in my classes because it takes too long for each student's brain to translate 'relinquished' and 'replacement', and as a result they miss what I say in the next few moments after I use those terms. 'Old' and 'New' are more familiar words to describe the legal, technical terms (and to be candid, it's hard even for me to keep 'relinquished' and 'replacement' straight while I'm in the middle of a lesson).

There are six basic requirements for a 1031 exchange. Teaching your students these basic requirements will teach them about 95% of everything they will ever need to know for a working knowledge about exchanges. And not incidentally, these are the same six things that the IRS looks at when they audit an exchange.

Before I start with the six things, let me point out that Section 1031 is broken into two sets of rules: those dealing with real estate (i.e., dirt and any thing that is screwed into it such as buildings, trees, rocks, water, etc.) and personal property (i.e., things that move such as jets, boats, trucks, cattle, tables, chairs, etc.). The rules are very different for real estate than they are for personal property. Since you are real estate educators, this article will address just those rules.

Rule #1 - Both the Old Property and the New Property must be held for investment or used in a trade or business. It used to be that if you sold a purple duplex, you had to find someone that also had a purple duplex and the two of you swapped deeds. This was changed during the late 70s and early 80s by T.J. Starker in a series of Supreme Court cases (thereby giving rise to the term "Starker Exchange").

In 1991 Congress rewrote Section 1031 and now you can sell your purple duplex and buy any other type of real estate, such as an office building, a warehouse, an apartment building or even bare land, as long as it too will be investment property for you or used in your trade or business.

Section 1031 says that property held for re-sale does not qualify for an exchange. This means that developers and "fix 'n flip" properties do not qualify for exchanges since the intent is resale rather than the holding for investment. There have been a number of court cases seeking to determine the dividing line between held for resale and held for investment. While intent is a significant factor in determining the difference, the consensus of the exchange industry is that a holding period of a year and a day is a minimum time frame distinguishing between the two. One of the primary reasons for this is that it keeps taxpayers from turning short-term capital gains into long-term capital gains by doing an exchange.

Another important part of this requirement is that you can not sell your Old Property to, or buy your New Property from, a related party. A "related party" is defined as your parents, grandparents, spouse, brothers & sisters, kids and grand kids. Thus, Aunt Martha is not related to you for this rule. There are similar rules for entities (e.g., corporations, partnerships, LLCs, etc.) owned by a related party.

A common question is whether the exchange property can be located outside of the United States. The answer is that if the Old Property is inside the U.S., then the New Property must also be inside the U.S. And if the Old Property is outside the U.S., the New Property must be outside as well. In other words, you can not cross U.S. borders with your 1031 exchange.

Rule #2 - 45 day identification requirement. From the day you close the sale of your Old Property, you have 45 days to complete a list of properties you want to buy. Typically this list will have 3 properties or less. This is because you can list up to three properties with no limitations. For example, if Fred & Sue Investor sold their Old Property for $100,000, they could list three properties for $10,000,000 each (a total of thirty million) because there are no limitations.

If your list has more than three properties, then the combined purchase price of all of the properties on the list can not exceed twice the selling price of the Old Property. This is called the 200% rule. Going back to Fred & Sue, if they put more than three properties on their list (it does not matter if the list has 4 or 400 properties), then the combined purchase price of all the properties can not exceed $200,000 (i.e. twice the Old Property selling price of $100,000). If you exceed the 200% limit, your whole exchange is disallowed. The common sense rule here is to keep your list to three properties or less.

The 45 days are calendar days. That means that if the 45th day falls on a Saturday or Sunday, or a holiday such as the 4th of July, or New Years Day - that is the final day: you must have your list completed by midnight on that day - there are no exceptions or extensions! If the IRS can prove that you changed your list after the 45th day, you and your Qualified Intermediary will go to prison (true!).

The list is given to the Qualified Intermediary whose job it is to receive the list on behalf of the IRS. See Rule #4.

The list has to be prepared in a way that an IRS agent could take the list and go directly to the door of the property. You want to list a property as "123 Main Street, Anywhere, USA." An identification such as "a three bedroom house on Main Street" won't work. In other words, the 45 day list must be specific and in writing.

Rule #3 - 180 day purchase requirement. This rule is pretty simple: again from the day of closing, you have 180 days to close the purchase of what you are going to buy, and what you buy has to be on your 45 day list. The 45 and 180 day requirements run concurrently meaning that when the 45 days are up, you only have 135 days left to close. And like the 45 day identification requirement, there are no extensions.

Closed means that risk of loss has to pass to you. In other words, title has to pass to you before the 180th day.

Rule #4 - Qualified Intermediary requirement. You can not touch the money in between the sale of your Old Property and the purchase of your New Property. By law you have to use an independent third party to handle the exchange.

The function of the Intermediary is to prepare the documents required by the IRS both at the time of the sale of the Old Property and at the time of the purchase of the New Property, and to hold the proceeds from the sale until the purchase of the New Property.

If the documents are not prepared correctly, the IRS will disallow the exchange. Yes, they do disallow exchanges for improper documents. Remember, the IRS loses a ton of tax to Section 1031, so they check to make sure that the documents are perfectly correct.

Section 1031 does not define who can be a Qualified Intermediary - it defines who can NOT be an Intermediary (in other words - who is disqualified). Included on the list of disqualified persons: the taxpayer's attorney and CPA, their realtor, any relative, any employee, and any business associate. This means that the Intermediary needs to be a completely independent party.

None of the 50 states, or the Federal Government, regulates Qualified Intermediaries. This means that a convicted felon could be an Intermediary and hold clients money. For this reason it is prudent to use caution in selecting an Intermediary. First of all, you want to make sure that they are bonded. As I write this there are approximately 2,000 Intermediaries in the United States. Of this amount only 39 are bonded, meaning that only a very small number have bothered with the hassles of back ground checks, etc. Don't automatically believe them when they say they are bonded - make them give you a copy of the bond.

Rule #5 - Title Requirement. Any entity, such as corporations, trusts, partnerships, LLCs, etc. may do an exchange. They all have the same rule: the tax return that holds title to the Old Property must be the same tax return that takes title to the New Property.

For example, if Fred & Sue are married (i.e., a joint return) and they sell the Old Property, Fred may not buy a replacement property in his name only. On the other hand, if Fred & Sue are brother and sister, then two tax returns own the Old Property and Fred may buy any New Property he wishes in his name only (the IRS looks only to his tax return to see if he met the title requirement).

Likewise, if a partnership, or LLC, owns the Old Property, then only one tax return (i.e., the partnerships) owns the property even though the partnership has many partners. If the partnership sells the property, then the partners may not do an exchange - only the partnership may. In these situations it comes down to "all or none" when the partnership is considering an exchange.

A solution that most attorneys devise to the problem of partners wanting to go different directions is to liquidate the partnership or LLC and give each of the partners a tenant-in-common interest in lieu of their partnership interest. The problem with this solution is the holding period requirement of one year and a day in Rule #1. In other words, if you dissolve the partnership today and close the sale of the property next week, each of the 'new' owners now has a one week holding period for their interest: meaning that they held it for resale and not for investment, which will result in the exchange being disallowed.

Can any of the partners sell their partnership interest and do a 1031 exchange? No - because they are not selling real estate, they are selling a partnership interest and the IRS does not allow exchanges of partnership interests.

Rule #6 - Reinvestment Targets. To defer all of your capital gains tax, you must buy a property of equal or higher value than the one you sold, and you must reinvest all of the cash proceeds from the sale. It sounds complicated but it's not. Let's assume the following set of facts:

Sale price of Old Property    $100,000
Debts paid at closing    40,000
Cash to Intermediary    60,000

Example #1: Fred & Sue sell their Old Property for $100,000. The mortgage on the property is paid off at closing and the balance of $60,000 is transferred to the Intermediary. If they buy their New property for $90,000, they've bought down by $10,000. The buy down does not kill their exchange, but the difference (between the Old sales price and the New purchase price) of $10,000 is taxable. The IRS calls this taxable amount "boot."

Example #2: Same facts, but instead of buying the New Property for $90,000, they decide to buy a New Property for $150,000 for which they are obtaining a loan for $100,000. This means that they will only use $50,000 of the $60,000 proceeds that the Intermediary is holding. The $10,000 excess is also boot and is taxable.

In both of the examples above, the entire $10,000 is taxable. In a 1031 exchange the gain is taxed first. Where you have a boot situation, the boot is taxable to the extent of the lesser of the boot or the entire gain on the transaction.

So let me restate this rule for you again: In order to pay zero tax, you have to do two things: you have to buy a property equal or higher in value than the one you sold, and you have to reinvest all of your cash. Now that we've worked through it, the rule should not seem so complicated.

Notice that you do not have to have debt on the New Property equal to or greater than, the debt that was paid off on the Old Property. There are people teaching 1031 classes that say this is so, but they're wrong; you simply have to buy equal or up and reinvest all your cash.

You shouldn't have any problems filling up an hour by walking your students through the six rules above. You can cover these six things in 15 or 20 minutes if you keep it really simple, or you can expand the class to an hour and a half or two hours by adding some more examples to each requirement. If you want to make sure that your examples are correct, you may call our national headquarters (toll free: 866-694-0204) and speak to one of our CPAs or attorneys free of charge.

In addition, we have many technical articles covering more advanced 1031 topics on our web site at expert1031.com. Feel free to incorporate these into your class. Again, if you wish to confirm that you are on the right track, feel free to call our office.