TM 1031 Exchange
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Do you believe the IRS is Santa Claus?

If your answer is "no", then read on.

To ensure a successful 1031 Exchange that can survive an IRS audit, investors must understand and follow the rules created by the IRS governing capital gains tax deferral via a 1031 exchange.

The primary causes of unsuccessful exchanges are improper documentation of the identification, failure to provide such documentation within the specified period and identifying unsuitable replacement properties.

Proper documentation should contain a specific description of the replacement property including the street address, city and state. Identification of Tenant In Common (TIC) property must also include the proportionate share (%) of the property that the investor intends to purchase. This information must be given to the Qualified Intermediary on or before the 45th day following the close of escrow of the relinquished property.

Suitability of a property takes into consideration the age and quality of the improvements, the quality of the tenant and how “certain” an investor is that the close of escrow will occur on time.

Some properties are more suitable than others. Investors involved in a 1031 exchange should look for clear and complete documentation (due diligence) on replacement properties they are considering. This documentation should cite all aspects of the investment, including tenant quality, existing leases and age and condition of the improvements. This allows investors to easily identify risks associated with the property, thus decreasing the chance of unknown obstacles affecting closing and increasing the probability of a successful exchange.

Properties packaged by TIC sponsors and newly developed properties are generally very suitable for exchanges A property packaged by a TIC sponsor will disclose all aspects of the investment, usually in the form of an “Offering Memorandum” or a “Private Placement Memorandum”. Newly developed property with a credit tenant (usually triple net leased) have a lower risk of an investor encountering obstacles to closing since both the developer and the new tenant will have recently inspected the property, identifying potential concerns and thereby eliminating surprises for the investor.

The high return on value-added or development opportunities is understandably attractive. However, due to the many “moving parts” involved, these investments are a much higher risk for a failed exchange. An investor can identify a value added or development property as a possible replacement, however a plan “B” is always recommended, following one of the three methods for identifying replacement properties. These are:

a) 3 property rule. Investor can identify a maximum of 3 properties, without regard to their value.

b) 200% rule: any number of properties can be identified, so long as their combined fair market value doesn’t exceed 200% of the value of the relinquished property.

c) 95% rule: any number of properties can be identified. The exchanger must close on properties with a value of at least 95% of the value of all the properties identified.

Other Key Terms & Rules:

Qualified Intermediary (QI)
A qualified intermediary holds the funds from the sale of the relinquished property. An investor is not allowed to control his/her own funds. There are rules specifying who can & cannot be a QI.

Like Kind: The relinquished and replacement properties must have been/be investments and/or used in a trade or business.

Of equal or greater value: The purchase price of the replacement property must be equal to or greater than the sale price of the relinquished property.

Same party. The tax return selling the relinquished property must be the tax return buying the replacement property. i.e., if title to the relinquished property is held in a partnership at the time of the sale, then the partnership must purchase the replacement property.

Timing: The replacement property must be identified on or before the 45th day following the close of escrow for the property being sold. The escrow for the purchase of the replacement property must close within 180 days following the close of escrow for the relinquished property.

Holding Period: The amount of time a property is owned is used by the IRS as an indication of intent. The rule of thumb is to hold a property for at least a year and a day before selling and using a 1031 exchange to defer taxes. This is to insure that the investor is not in the “business” of buying and selling property for profit.

An informed investor and a well planned exchange are the best tools to successfully complete a 1031 exchange that can survive even an IRS audit .

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