Commonly asked questions about 1031--Part 2.

This article is a continuation of Part 1 of the article by this same title and intended to respond to questions commonly asked by many investors contemplating a tax deferred exchange. As mentioned below, investors should be careful not to generalize and to ask a lawyer and CPA for advice to determine how these general guidelines apply to their facts and circumstances.

Q: How much do I need to spend to defer 100% of my taxes?

A: To defer 100% of one's gain, an investor needs to spend all of the net equity from the sale on the purchase of replacement property and acquire property with equal or greater debt on it as the relinquished property had prior to sale.

One exception to this rule is that investors can always replace any debt reduction with additional cash. Net equity is defined as equity less mortgage debt and exchange expenses. Exchange expenses do not include all closing costs however. Exchange expenses are defined as those expenses one typically incurs in connection with the purchase and sale of real estate. Specifically, items that are prorated or adjusted at closing are not exchange expenses and if deducted from equity will result in taxable boot. Another way to view this requirement is to trade up or even and spend all of one's net equity.

Q: Can I buy or sell more than one relinquished or replacement property in one exchange?

A: Yes, you can sell multiple relinquished properties and/or buy multiple replacement properties in one exchange.

Q: Can I take title to my replacement property before I sell my relinquished property?

A: Yes, this is known as a reverse exchange. To fit within the safe harbor provisions of the IRC, one must comply with the requirements of Rev Proc 2000-37.

This Rev Proc requires that either the replacement property or relinquished property be parked with a qualified intermediary or an affiliate thereof during the exchange period since if the investor has title to both properties at one time there would be no exchange. Many factors must be taken into account in determining whether it is more beneficial to park the relinquished or the replacement properties.

It is essential that investors seeking to conduct a reverse exchange review the pros and cons of each with a qualified advisor and also begin such analysis well before they are ready to close on the replacement property.

Q: Can I make improvements to property I already own and acquire the improved property as my replacement property?

No, Rev Proc 2004-51 put an end to building on one's own property and taking title to such property as improved even if one transfers the property to an intermediary or other agent first which holds the property during the 180 day exchange/improvement period and then transfers it back as improved.

Rev Proc 2004-51 specifically disqualifies deferred exchanges where the property has been owned by the taxpayer any time within the last 180 days. This Rev Proc had no effect on improvement exchanges where the taxpayer has not owned the property or held qualified indicia of ownership within 180 days of taking title to the property.

Thus, improvement exchanges may still be safely completed under the Code as long as the property to be improved and acquired as one's replacement property has not been owned by the taxpayer any time during the preceding 18-month period.

Q: How long must one hold title to property to be qualified to perform a [section] 1031 exchange?

A: The rules do not specify any particular holding period which will automatically qualify or disqualify an investor for an exchange. To qualify to perform an exchange, an investor must be deemed to have held property with for use in a trade or business or for investment. The IRS considers about eight separate factors in determining whether a taxpayer holds property with investment intent.

The holding period is only one of those factors. That said, the IRS in one private letter ruling determined that a two year holding period was a sufficient period to establish investment intent (PLR 8429039). Note however that the investor at issue had not engaged in resale activities during that two year period. An alternative view held by many legal and tax advisors is that a one year holding period is sufficient to establish investment intent.

I would, however, caution investors by saying that if during that one year period the taxpayer has taken actions which would only be taken if the investor was contemplating the imminent sale of the property (i.e. listing the property for sale, subdivision efforts, entering into negotiations for sale or a contract for sale), then the one year hold period would likely be considered tainted and the transaction disqualified in the event of an audit.

I would further caution that, if there is evidence of resale activities over a significant period of time, this fact will likely prevail and negate any investment intent otherwise established by a long holding period regardless of the duration of the holding period.