1031 Exchange

1031 Exchange

A transaction that permits taxpayers to sell an asset held for investment or business purposes, use the proceeds to purchase a like kind investment and defer paying capital gains taxes. A 1031 exchange is also known as a deferred 1031 exchange, 1031 tax exchange and 1031 deferred exchange or Starker Exchange.

Accelerated Depreciation

A method of depreciation that allows you to deduct a greater portion of the cost of the depreciable property in the first years after the property is placed in service, versus spreading the cost evenly over the life of the asset, as with the straight-line depreciation method.

Accommodator

The unrelated third party that facilitates a 1031 exchange. Also known as the qualified intermediary, QI, facilitator, qualified escrow holder.

Actual Receipt

This refers to the exchanger having direct access to the funds of the relinquished property. Also know as Constructive Receipt, can invalidate a 1031 exchange.

Adjusted Basis

The net cost of an asset after adjusting for various tax related items. Adjusted Basis = Purchase Cost + Improvements + Fees (selling costs and legal fees) Accumulated Depreciation Other Losses. This is used in calculating capital gains when an asset is sold and also known as the Adjusted Cost Basis.

Agent

An entity that acts on behalf of the taxpayer. A QI cannot be your agent at the time of the 1031 exchange. For 1031 exchange purposes, an agent includes your employee, attorney, accountant, investment banker, commercial real estate agent or broker within the two-year period prior to the transfer of your first relinquished property

Agreement For Transfer

Purchase agreement, offer and acceptance, sale agreement, earnest money agreement, real estate contract, or other contract contemplating the purchase of sale of real property.

Balancing the Exchange

This refers to a 1031 exchange where the exchanger has deferred 100% of the capital gains taxes and depreciation recapture. To achieve this the exchanger should (A) purchase a property or properties that are equal to or greater than the value of the commercial property sold (B) use all the equity acquired from the sale of the relinquished property towards the purchase of the replacement property (C) obtain the same or greater debt on the replacement property that was on the relinquished property.

Boot

Property or cash the taxpayer receives in the 1031 exchange that is not considered “like-kind” and thus is taxable.

Built to Suit Exchange

A 1031 exchange where the QI acquires and holds the title to the replacement commercial property on behalf of the exchanger while the structures or improvements are built or installed on the replacement property.

Business Asset

Real property, tangible depreciable property, intangible property and other kinds of properties used in business. Exchanging one business for another is not permitted under the IRS Section 1031.

Capital Gain

The difference between the selling price of a property or asset and its Adjusted Basis.

Capital Gain Tax

Tax levied by Federal and State Governments on investments such as commercial real estate income properties that are held for one year or more.

Capital Improvements

The expenses of upgrading a commercial property rather than repairing it or maintaining it. The costs of the improvements are added to the basis of the property. If the building is being depreciated, the improvements also should be depreciated over the same useful life as the building.

Collectibles

Personal property (ex. coins, stamps, art) that is held for investment. They are exchangeable and not subject to the same rate of taxation.

Community Property

Property acquired by a husband and wife during their marriage. Each spouse has equal rights. Inheritances and gifts are treated as separate property. Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin are community property states.

Concurrent Exchange

A 1031 exchange in which the disposition of the relinquished property and the acquisition of the replacement properties close at the same time. Also known as a Simultaneous Exchange.

Construction 1031 Exchange

A type of 1031 exchange that allows the exchanger to purchase a commercial property that is not yet completed as long as it will be before the 180 day exchange period limit has expired. These types of exchanges are more complicated and more fees are involved than in a regular 1031 exchange. See Exchange Accommodation Taxpayer (EAT) below.

Constructive Receipt

This refers to the exchanger having direct access to the funds of the relinquished property. A constructive receipt invalidates a 1031 exchange and also know as Actual Receipt.

Contract Exchange

A 1031 exchange on an open option to purchase or an open Sales Contract instead of on the real estate itself.

Cooperation Clause

Language included in the Purchase and Sale Contracts for both relinquished and replacement property that states the transaction is part of an intended 1031 exchange and requires all parties to cooperate in completing the 1031 exchange.

Deduction

An amount that can be subtracted from gross income or from a gross estate lowering the amount on which tax is assessed.

Deferred Exchange

A transaction that permits taxpayers to sell an asset held for investment or business purposes, use the proceeds to purchase a like kind investment and defer paying capital gains taxes. A deferred exchange is also known as a deferred 1031 exchange, 1031 tax exchange, 1031 deferred exchange or 1031 exchange.

Delaware Statutory Trust (DST)

A Delaware Statutory Trust, also known as a DST, is a separate legal entity created as a trust under Delaware statutory law. Delaware law permits a very flexible approach to the design and operation of the entity. A DST may be used in in a Section 1031 tax-deferred exchange private placement program if structured in accordance with the provisions of IRS Revenue Ruling 2004-86.

Delayed Exchange

A 1031 exchange where there is a period of time between the closing of the relinquished property and the closing of the replacement property.

Depreciable Property

Property with a useful life of more than one year that is held for investment or used in your trade or business. The cost of the asset is spread over the estimated useful life of the property.

Depreciation

The reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion or other such factors. One is allowed to deduct depreciation from income on his or her income tax return.

Depreciation Recapture

The procedure used by the IRS for collecting income tax on a gain realized by a taxpayer when the taxpayer disposes of an asset that had previously provided an offset to ordinary income for the taxpayer through depreciation. In other words, because the IRS allows a taxpayer to deduct the depreciation of an asset from the taxpayer’s ordinary income, the taxpayer has to report any gain from the disposal of the asset (up to the recomputed basis) as ordinary income, not as a capital gain.

Direct Deeding

Deeding the relinquished property directly to the buyer and than having the seller of the property which you are buying deed his property directly to you, skipping the deed to an intermediary.

Disposition

The sale or other disposal of property that causes a gain or a loss including like-kind exchanges and involuntary conversions.

Equity

An escrow account that limits the exchanger’s rights to benefit from the cash received from the sale of the relinquished property. It also ensures that the funds are protected against claims from creditors of the QI.

Qualified Exchange Accommodation Arrangement

The contractual arrangement between the exchanger and the Exchange Accommodator Titleholder (EAT).

Qualified Intermediary (QI)

The unrelated third party that facilitates a 1031 exchange. Also known as the accommodator, facilitator, or qualified escrow holder.

Qualified Use

In a 1031 exchange, the exchanger must have the intent to hold the property for investment or for income production in order to satisfy the qualified use test.

Real Property

Land, land improvements resulting from human effort including buildings and machinery sited on land and various property rights over the preceding (ex. homes, apartment buildings, shopping centers, commercial buildings, factories, condominiums, leases of 30-years or more, quarries and oil fields.) All types of real property are considered like-kind and thus exchangeable for all other types of real property in a 1031 exchange.

Real Estate Exchange

The exchange of real property for real property. All kinds of real property are considered like-kind for other real properties. See Real Property above.

Relinquished Property

In a 1031 property exchange, the original property being sold by the exchanger.

Replacement Property

The 1031 replacement property being purchased in a section 1031 exchange.

Reverse Exchanges

A 1031 real estate exchange in which the Replacement Property is purchased before the sale of the Relinquished Property.

Rules of Identification

Guidelines that must be followed when identifying properties in a 1031 deferred exchange. They are the 95% Rule, 200% Rule, and Three Property Rule.

Real Estate Investment Trust (REIT)

A trust that invests in real estate and mortgages and passes income, losses, and other tax items to its investors. REITS are typically classified as a security and are therefore not exchangeable.

Related Person

As described by the IRS, any person bearing a relationship to the exchanger (spouse, child, sibling, parent, grandparents but not aunts, uncles, cousins or ex-spouses), a corporation in which the exchanger has more than a 50% ownership, and a partnership in which the exchanger owns more than a 50% share of the capital or profits.

Safe Harbors

Regulations established by the IRS that assist exchangers and QI’s structure a successful 1031 exchange.

Seller Carry-Back Financing

When the buyer of a property gives the seller a note secured by a deed of trust or mortgage. In a 1031 tax free exchange this type of financing is treated as boot unless it is sold on the secondary market or used as a down payment for the property.

Settlement Agent

Title agent, closing officer, escrow officer, settlement officer, closing agent, closing attorney, settlement attorney.

Simultaneous Exchange

A 1031 investment exchange in which the disposition of the relinquished property and the acquisition of the replacement properties occur at the same time. Also known as a Concurrent Exchange.

Starker Exchange

Another name for the IRS 1031 exchange. It is named after a court decision made in Starker vs. Commissioner in 1979 that set the precedent for our current day 1031 exchanges.

Straight-line Depreciation Method

A depreciation method that spreads the cost or other basis of property evenly over its estimated useful life.

Taxpayer

Client, investor, exchanger.

Tax Deferral

The postponement of taxes to a later year. This is often done by recognizing the income at a later time. 1031 exchanges are a common method of deferring capital gain.

Tax Deferred Exchange

The procedure outlined in Internal Revenue Code Section 1031 that allows capital gains tax to be deferred as long as all the regulations are followed. Also known as 1031 exchange, delayed exchange, like-kind exchange, section 1031 exchange, tax-free exchange, nontaxable exchange, real estate exchange, real property exchange, Starker exchange.

Tenancy In Common (TIC)

Tenants in Common, also known as a TIC, is fractional ownership interest in a piece of property.

Three Property Rule

In 1031 tax exchanges the exchanger may identify up to three properties without regard to their value.

95% Rule

In tax-deferred exchanges, the exchanger may identify any number of properties without regard to their value as long as the exchanger purchases 95% of the fair market value of the properties identified.

200% Rule

The exchanger may identify more than three properties provided their fair combined market value does not exceed 200% of the relinquished property in a 1031 exchange.

We hope these terms help you to better understand the commercial income producing properties that we sell and trade daily to avoid tax consequences at the time of sale.