WHAT IS AN EXCHANGE?

When an individual gives up an asset and in return receives a different asset, an exchange has taken place. Every day each of us gives up money (an asset) in return for the products we buy (another asset), thus we have exchanged money for goods. Real property exchanges involve only real property. An owner can relinquish one property and receive one or more properties in return. When this happens (and all government rules are complied with) a real property exchange has taken place. One can exchange personal property for personal property or exchange real property for real property, but one cannot exchange real property for personal property or vice versa¹. This site will only discuss real property exchanges.

Any real property may be exchanged for any other real property, provided that:

• The property involved is neither your primary residence or a second home, and
• It is not “dealer” property. Dealer property is property held for sale to customers in the normal course of business.
• Primary residences may no longer be exchanged because that law (Section 1034) has been repealed.
• Second or vacation homes do not qualify for Section 1031 exchanges.
• Dealers may participate in an exchange, but to the extent their property is selling at a profit, they will pay ordinary income tax on the profit.

WHY BOTHER? WHY NOT SELL AND REPURCHASE?

When real property is sold, the relinquishing owner must report the sale to the government and pay taxes on any profit. The tax amount may be a substantial part of the net equity, leaving only a portion of the cash proceeds to reinvest. The amount of equity remaining, after the taxes have been paid, may not be enough to acquire the replacement property.

An exchange on the other hand permits the deferment of taxes so that the amount that would have been paid to the government in taxes is available for your use to acquire the replacement property.

WHY DOESN’T EVERYONE EXCHANGE THEN?

Real estate exchanges for the deferment of taxes only work if the relinquished rental investment property is to be replaced with other property to be held for rental or investment. It is not permissible to exchange for stocks, bonds, notes or other evidences of indebtedness or for interests in a partnership.

Property acquired in a tax deferred exchange under the provisions of Section 1031 must always be held for rental purposes or for investment. There are no provisions in the Code permitting occupancy of that investment property as a residence without incurring tax liability²

An exchange is only beneficial if there is a significant profit in the relinquished property. If there is no profit, then there would be no tax. If there is no tax, there is no need to exchange. Merely sell the property and pocket the proceeds. An exchange is a legal tool to avoid the payment of tax if the taxpayer is planning to reinvest in real estate.

An owner may wish to defer the payment of tax on the sale of his property if his reason for disposing of the relinquished property was to replace it with another property in a different location. Perhaps the motivation is merely to replace it with a property more easily managed or more easily financed. Because an owner may move there is often a geographical reason for entering into an exchange. Most owners avail themselves of the provisions of tax free sale of real estate, because they wish to acquire larger, better situated, newer properties with attendant bigger cash flows.

Remember that an exchange is a reciprocal transfer of property without the intervention of money and that each property is being transferred in consideration of the other. To start the process the relinquished property must be sold. To achieve a trouble free exchange, follow these steps:

A tax deferred exchange has been accomplished if the taxpayer (exchanger) can conclusively state that he or she has received none of the following:

• No cash
• No “boot” (non-qualifying property)⁷
• No “mortgage relief” (a mortgage secured by the replacement property smaller than the mortgage than encumbered the relinquished property. This definition applies to all types of financing, whether it is called a mortgage or some other name)All the transfers must have occurred within the specified time frame and in the proper sequence.
• To be sure the above conditions have been met, a simple way to calculate what must be paid for the replacement property, and still defer taxes, is to subtract the costs of the transfer (commissions, title search, escrow fees, legal fees, etc., but not prorated real property taxes, maintenance fees and the like) from the sale price of the relinquished property and be sure to pay this amount or more for the replacement property. One must always be sure to use all of the equity from the sale of the relinquished property and to end up with a new mortgage equal to or greater than the one encumbering the relinquished property.

If related parties exchange property and either of the related party or the exchanger sell either of the properties acquired in the exchange within two years of the time the last of the properties in the exchange was transferred all gain will be recognized (taxed) as of the date the exchange took place. (The service will also charge a penalty for not paying the taxes when due and interest on the unpaid taxes!)

A related party is:

• Members of a family
• An individual and a corporation if the individual owns more than 50% either directly or indirectly of the corporation.
• Two corporations which are members of the same controlled group.
• A grantor and fiduciary of any trust
• A fiduciary of a trust and the beneficiary of that trust.
• A fiduciary of a trust and a corporation which is owned 50% or more directly or indirectly by a person who is grantor of the trust.
• A corporation and a partnership if the same persons own 50% or more of both the corporation and the partnership.
• S corporations and S and C corporations if the same persons own more than 50% of the controlling interest in each entity.
• Partnerships or more than one partnership if the same person owns more than 50% of the controlling interest in both entities.

The subsequent transfer of property will NOT trigger a tax in a related party exchange if:

• The transfer is as a result of the death of either the taxpayer or the related party.
• If the transfer is a result of compulsory or involuntary conversion (condemnation or other disaster) and the exchange occurred before the threat of condemnation, or
• It can be established to the satisfaction of the Secretary of the Treasury that neither the transfer nor the exchange had as one of its principal purposes the avoidance (evasion) of Federal income tax.

Rev. Rul. 2002-83

PARTNERSHIP INTERESTS

Both the Code and the Regulations prohibit the exchange of interests in a partnership. However, the Code also states that if a partnership has in effect a valid election under Section 761 (a) of the Code, excluding the partnership from all the requirements of partnership taxation, then the exchange of a partnership interest shall be treated as though it were an exchange of the partnership’s underlying assets and not as an interest in a partnership.

• Careful analysis of the partnership rules and Section 761(a) and the Regulations thereunder seems to indicate that Congress was attempting to permit the exchange of what you and I would call an investment”, that is, an interest in property, and there were more than one owner.

EXAMPLE: Three brothers decide to buy some raw land as an investment. Several years later the land has appreciated and one of the brothers would like to acquire some income property. If the other brothers agree to buy him out, or if he finds an investor for his share the other brothers will accept as a co-owner, the exchanging brother may enter into and complete the exchange because: a) the brothers own the property as co-owners, b) They did not conduct a business, and c) theirs is not a related party exchange.

EXAMPLE: Three unrelated friends decide to acquire an improved property which they plan to rent out. Some years later during which time the property has been rented and each owner has filed tax returns accurately showing the income and deductions to which the taxpayer is entitled, one of the owners would like to acquire other income property as a sole owner and the others would just as soon sell. The sale takes place, the one owner completes an exchange for property that qualifies and the others take their cash, pay the tax on the gain (profit) and go on their way. Rental property generally qualifies for a Section 761(a) exemption, because it is not a business. Be careful that the owner(s) do not provide personal services, and check with your tax person regarding Section 761(a) if more people than a married couple filing jointly own the property and they are not all going to be on title on the replacement property. If requested, we will provide you with a copy of Section 761(a)

• Thus, a group of people who hold property as tenants-in-common, probably may exchange separately into different properties, provided they have a valid Section 761(a) in place, or can get one.

A foreign person is a person subject to the withholding provisions of Section 1445 (The Foreign Real Property Tax Act, commonly known as “FIRPTA”) and is an individual or a nonresident fiduciary who is not a U.S. citizen or resident. Resident aliens are not subject to withholding if they possess a “green card” (an Immigrant visa) or can satisfy the substantial presence test”.

Under this test the individual must at least (1) be physically present in the United States for 31 days during the calendar year, and (2) 183 days during the current year and the preceding two years counting all the days of the physical presence in the current year, but only a the number of physical presence days in the preceding year and only 1/6 of the number of physical presence days in the second preceding year.

• The nonresident spouse is subject to the withholding rules for all income except wages.
• The Buyer (transferee) of United States property which was owned by a foreign person, a foreign corporation (which has not made an election under Section 897(i)), foreign partnership, foreign trust or foreign estate, MUST WITHHOLD 10% OF THE GROSS SALES PRICE OF THE PROPERTY AND PAY IT OVER TO THE IRS. The Buyer must file form 8288 and 8288-A to report and pay over the tax, which must be paid within 20 days of the close of the transaction.
• A withholding certificate may be obtained from the IRS allowing adjustments to be made regarding the amount to be withheld. One of the conditions under which the IRS will issue a withholding certificate is if the foreign seller is subject to the exemption of all tax on the gain in the relinquished property due to the provisions of Section 1031. However, the IRS will act upon the issuing of a certificate within 90 days of their receipt of the completed application. This potential 90 day period could easily defeat an exchange by a foreign person.
• No tax need be withheld if the seller issues the buyer a certificate stating under penalties of perjury that he or she is NOT A FOREIGN PERSON, signed and giving an address, and a taxpayer identification number. If the buyer has actual knowledge that the above mentioned certificate is false, disregard the notice and withhold and send in the tax!
• No tax need be withheld if the seller issues the buyer written notice that no gain will subject to tax because of the provisions of Section 1031, which must be filed with the IRS within 20 days of the transfer, then no tax need be withheld, unless, of course, there is actual knowledge that the written notice is false.
• No tax need be withheld if the buyer did not pay more that $300,000 for the property and intends to use it as a primary residence.
• Thus a foreign person or entity has three choices:
  1. Certify under penalty of perjury they are NOT A FOREIGN PERSON,
  2. Sell property for not more than $300,000 to be used as a residence, or
  3. c) submit written notice that the transaction qualifies for non-recognition under the provisions of Section 1031.

• Types of Exchanges