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REQUIRMENTS » WHY EXCHANGES FAIL
Each Exchange is unique. Be sure you understand the details of your particular situation before beginning the Exchange Process. Give Exchange Authority a call at 978-433-6061, we'll be happy to answer any and all of your questions.
In order to qualify for tax-deferred treatment under IRC §1031, certain requirements must be met.
This page provides a great deal of information on various requirements including:
IRC §1031 specifically excludes some types of property from an exchange.
Learn more about different types of exchanges.
Property held by the taxpayer as inventory in his trade or business, such as the shelf items on the taxpayer’s hardware store shelves, or development lots owned by the taxpayer and held primarily for sale to individuals are deemed to be “dealer property” – property held primarily for sale – and do not qualify for an Exchange.
Partners in a partnership or beneficiaries of a trust may not exchange their partnership interest (limited or general) or beneficial interest, and shareholders of corporate shares of stock may not exchange their individual holdings. These exclusions, however, do not prevent a corporation, partnership or trust from exchanging assets of the corporation, partnership or trust for other assets of like kind to be held by the same entity.
In general, all other property, both real and personal, can qualify for tax-deferred treatment as long as the relinquished property and the replacement property are like kind (or like class) and both properties are held by the taxpayer for qualifying purposes.
Real property, however, is NOT like kind to personal property.
A duplex and a race horse are not like kind.
Remember, though, that while real property can be exchanged for like kind property, the purpose requirement discussed above still applies. That means that the properties, no matter what kind or interest, must be held for productive use in a trade or business or for investment.
Converting the use of a relinquished property from personal use to use in a trade or business (rental property) must be documented sufficiently in advance of the Exchange to qualify the property under the purpose requirement.
IRC §1031 says that “No gain or loss shall be recognized on the Exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
That means that to qualify for tax-deferred treatment, the relinquished property must be held by the taxpayer for productive use in a trade or business or for investment and, in the Exchange, the taxpayer must acquire property that he/she intends to hold for productive use in a trade or business or for investment. Property held for such purposes is considered qualified use property and meets the purpose requirement for an exchange.
All real property that is rented to others at fair market rent and all property held by the taxpayer for use in a trade or business is property held for the productive use in a trade or business. However, if the taxpayer moves into the rental property or rents it below market rates, then the property is considered property held for personal use and no longer qualifies for Exchange purposes. Any real property other than the taxpayer's personal use property (property held as the taxpayer's personal residence or second home) or dealer property (property acquired for resale) qualifies and meets the purpose requirement for an exchange
IRC §1031 and the exchange regulations do not define how long a relinquished property or replacement property must be held for qualifying purposes prior to an exchange or after an exchange in order to characterize the properties as "qualified use properties". A literal interpretation of the code and the regulations would imply that if the relinquished property and the replacement property were held for qualifying purposes on the day of the exchange, that is sufficient, the properties qualify for the exchange.
Conversely, in a private letter ruling, the IRS concluded that property held for a qualifying purpose for a two year period may adequately demonstrate that the purpose requirement had been met. In other instances, the IRS has stated that relinquished property acquired just prior to an exchange or replacement property disposed of shortly after an exchange have not been held for the qualifying purposes. The courts have been less restrictive. In one case, the court ruled that the gifting of replacement property eight months after the conclusion of the exchange did not violate the exchange.
In conclusion, there is no absolute or safe holding period. Property will be considered qualified use property based on all of the facts and circumstances surrounding the ownership and use of the property including the holding period. A long holding period is better than a short holding period. A one year holding period may be sufficient. A two year period is more conservative.
IRC §1031 specifically requires that an Exchange take place. That means that one property must be exchanged for another property, rather than sold for cash.
The Exchange is what distinguishes an IRC §1031 tax-deferred transaction from a sale and purchase.
The Tax Reform Act of 1984 imposed time restrictions for Exchanges. For an Exchange in which the taxpayer will acquire the replacement property after transfer of the relinquished property, two time limits are established:
The taxpayer is required to identify the replacement property within 45 days after transfer of the relinquished property.
The taxpayer must receive title to the replacement property before the earlier of (a) 180 days after the transfer of the relinquished property, or (b) the due date of the taxpayer's federal income tax return, including extensions, for the year in which the relinquished property is transferred. The reason for these time limits is simply one of administrative convenience.
Whether the taxpayer transfers one or more than one property as part of one Exchange, the number of replacement properties that may be identified is:
Up to three properties, without regard to their fair market value (the “3 property rule”) or
More than three properties if the total fair market value of all identified properties does not exceed 200 % of the total fair market value of all property relinquished (the “200% rule”).
If the taxpayer fails to meet either the 3-property rule or the 200% rule then he/she must acquire 95% of all property identified (the “95% rule”). If the taxpayer fails to meet the requirements of one of the rules, then all property acquired in the Exchange will be deemed not to be like kind. The Exchange shall fail by virtue of the fact that the taxpayer received only non-like kind property and gain will be recognized to the full extent of the realized gain.
If the taxpayer actually receives the proceeds from the disposition of the relinquished property, the transaction will be treated as a sale and not as an Exchange.
Even if the taxpayer does not actually receive the proceeds from the disposition of the property, the Exchange will be disallowed if the taxpayer is considered to have "constructively" received the proceeds.
The code and regulation provide that income, even though it is not actually reduced to a taxpayer's possession, is constructively received by the taxpayer if it is:
However, income is NOT constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Therefore, a crucial question in every Exchange is whether the taxpayer's control over the proceeds from the disposition of the relinquished property is substantially limited or restricted.
A number of complicated rules exist to help a taxpayer and his/her advisors structure an Exchange so that the taxpayer will not be in constructive receipt of the funds. The principal means following the adoption of the final regulations is the use of a Qualified Intermediary.
For questions on Exchanges be sure to call New England's 1st Authority on IRC §1031 Exchanges.