Equity and Gain are both important to an exchange, but they are never the same number. Let's take a cursory look at how you determine both equity and gain?

First equity represents the hard earned value that is yours in any property you own. So, if you take your gross selling price and subtract your closing expenses or closing costs, and then further subtract the amount of any debt, that remaining number which is left over will be your equity.

Now how about capital gain? Well in order to determine gain we need to know what is called your costs basis. And your cost basis is going to be informed by when you bought the property. So when you bought the property you had a purchase price correct? Well that will be the start of your cost basis, which actually changes over time. For instance, if you've done any improvements to the property that amount should be added. And likewise, if you've deducted any depreciation while you've owned the property that will be subtracted. Therefore, lets determine your cost basis and gain this way: Let's find our final cost basis or adjusted basis. That will be our original purchase price, plus any improvement, and then less any depreciation, that gives us our final adjusted basis. Now let's once again take that net selling price from our sale, deduct our final adjusted basis, and bingo, that's our capital gain.

One last thing. Here is a very simple rule that works in exchanges if you want to have a totally tax free transaction. And that is this.. do these two things and your exchange should be tax free. Number 1, buy a replacement property that is equal or greater in value than your net selling price, and 2) move all your equity from the old property into the new one. If you do those two things, plus replace your debt, you'll be in excellent shape.

Any tax deferred exchange completed pursuant to Section 1031 needs to involve like kind properties.

So what is the definition of like kind?

Well, first, it is important to remember that like kind refers more to the way a property is used rather than the way it looks.

For instance, the typical single family detached home can be both a personal residence or an income property, right? Okay, so then the definition for like kind essentially boils down to you needing to use your property in one of two ways. And those two methods which make up like kind are property held for investment, and property held for a productive use in a trade or business. Basically property held for income.

So as you are out looking for candidate replacement properties, make sure your use of that new property will fit within one of those two categories. And that is the definition of like kind.

Because exchanging represents an IRS recognized approach to the deferral of capital gain taxes, it is important for us to appreciate the components and intent underlying such a tax deferred or tax free transaction.

It is within Section 1031 of the Internal Revenue Code that we find the core essentials necessary for a successful exchange. Additionally, it is within the Like-Kind Exchange Regulations, previously issued by The Department of the Treasury, that we find the specific interpretation of the IRS and the generally accepted standards and rules for completing a qualifying transaction.

There are only a few rules which are critical to making your exchange qualify and one of the most significant is the allowance of time in which you have available to complete a delayed or deferred exchange. So here are the two time sensitive rules you need to remember.

Okay, first important time rule. You have a total of 180 days in which to sell your relinquished or exchange property and actually buy and close on your replacement property or properties. That is called the exchange period. Also, if you buy more than one, make sure the last one you close is still within that 180 day window or it won't qualify.

Now often you'll hear a qualifier or caveat regarding the 180 day exchange period which can be very important. And that is this: you actually have 180 days or whenever your tax return is due, which comes first. So what does that mean? This………. If you close your relinquished or exchange property late in the year, say for instance around Thanksgiving, you won't have a full 180 days between then and you're your tax return is due on April 15th correct? Okay, so if that is the case for your transaction, in order to get the full 180 days you will be needing to file an extension in order to include your exchange in your return. That's what that tax return qualifier really means.

Okay, second important time rule. In addition, after you close your relinquished or exchange property, you'll have 45 days from that closing in which to name candidate or targets properties in which to exchange. So that first 45 days out of the total of 180 is called the exchange period.

Also, this is important to remember. You must identify under some basic rules. The only time you don't really have to identify is if all your replacement property is already closed within that 45 day window. That's kind of de facto identification anyway isn't it?

There are two rules for identifying and one exception which we cover elsewhere, but let me give you the rule which is used 95% of the time. It is this. The three property rule. And it is this: You can name or identify any three properties of any value. But your identification must be in writing, and it must be transmitted or postmarked within that 45 day period. Now you can use our online identification tool in the Exchanger Portal if you prefer. It simply handles the transmission aspect electronically and the signatures are digital. But it is pretty convenient if you are on vacation, and today is your 45 day and all you have is a smart phone. But those are the basic rules.

Although the vast majority of exchanges occurring presently are delayed exchanges, let us briefly explain a few other exchanging alternatives.

Simultaneous Exchanges

Investors have been doing simultaneous exchange s since the 1920's. In fact, prior to Congress modifying the Internal Revenue Code as to exchanges and formally approving the concept of delayed exchanging, virtually all exchanges were of the simultaneous type. To qualify as a simultaneous exchange, both the relinquished property and the replacement property must close and record on the same day.

Improvement and Construction Exchanges

In some cases, the replacement property requires new construction or significant improvements to be completed in order to make it viable for the specific purpose that an Exchanger has intended for it. This construction or improvements can be accomplished as part of a structured exchange process, with payments to contractors and other suppliers being made by the facilitator out of funds held in a trust account. Therefore, for instance if the replacement property is of lesser value than the relinquished property at the time of the original transaction, the improvement or construction costs can bring the value of the replacement property up to an exchange level or value which would be equal to the relinquished thereby allowing the transaction to remain tax free. Improvement and construction exchanges can be tricky however. That's because the process does require the use of a concept which we use in reverse exchanges. Namely, a warehousing of the title until such a time as the improvements are done or the 180 days is close. This is because technically you cannot exchange into property you already own. So if you bought the replacement and then did the improvements, the value you added would not count towards the exchange. That is why we use what is called an EAT or exchange accommodation titleholder.

Reverse Exchanges

The reverse exchange is actually a misnomer. It represents an exchange in which the Exchanger locates a replacement property and wants to acquire it before the actual closing of the relinquished or exchange property. Since the Exchanger cannot purchase the replacement and later exchange into property that he already owns, he must find a method to acquire the replacement property and still maintain the integrity of his exchange. Reverses are typically accomplished in two formats based upon transaction logistics and the financing needs of the Exchanger. The Exchange Last strategy is utilized only when the Exchanger requires traditional financing to complete his acquisition of the replacement property. Since few lenders would lend dollars to the Exchanger with the facilitator or Qualified Intermediary (known in this case as an Exchange Accommodation Titleholder) on title, it is necessary for the facilitator to warehouse or hold the title to the relinquished property. In this approach, the exchange is complete at the moment the Exchanger accepts the title to the new replacement property. However, with the prospect of the exchange being complete, it is necessary to balance equities between relinquished and replacement, prior to closing. In other words, upon closing the replacement, there must be an equal amount of equity in the replacement property as is expected to come out of the later sale of the relinquished property. Then, at the time of the later sale of the relinquished or exchange property, any debt is retired and the Exchanger is repaid any dollars which he advanced for the replacement property acquisition. In an Exchange First scenario, the facilitator, with the aid of a loan from the Exchanger, acquires the replacement property and warehouses or holds the property title until such time as the relinquished property is sold and the exchange can be completed.

At this point we need to insert several caveats regarding reverse exchanges. They tend to be more complicated than other exchanges and because they involve the holding of title by a facilitator in the form of an Exchange Accommodation Titleholder, they require extensive planning. Do not undertake a reverse exchange without the assistance of an experienced and knowledgeable facilitator or intermediary.

Delayed or Deferred Exchanges

Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange. In a delayed exchange, the relinquished property is sold at Time 1, and after a delay, the replacement property is acquired at Time 2. The timing requirements are these: you have a total of 180 days or the due date of your tax return to complete an exchange. That is the exchange period. And, the first 45 days of the 180 is known as the identification period in which you need to identify some candidate or target properties to serve as your replacement. And that's the types of exchanges.

Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange.

To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20%-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70%-80% of what it did previously.

When you carry back financing for your buyer in a 1031 exchange it is important to realize that the Promissory Note that you will be carrying will be considered 'non like kid property' for the purposes of your exchange. Namely, the amount that you carry back cannot be included in your exchange because the Promissory Note is considered an evidence of indebtedness, rather than real property.

This means that the Promissory Note will be taxed like an installment sale pursuant to Section 453 of the Internal Revenue Code. Menaing that you will pay tax on principal as it is received.

Carry Back Alternatives

We have seen some Exchangers include a carry back Promissory Note in their exchange by making the Note payable to their Qualified Intermediary. This allows the Exchangers some time in case they would like to make the Promissory Note part of their downpayment on a replacement property, thereby coverting the Note from an evidence of indebtededness back into real property which qualifies for deferred gain treatment for exchange purposes.

Also, it is possible for the Exchanger to buy their own Note either out of the original closing, or purchasing it from the Qualified Intermediary, thereby representing another method for converting an evidence of indebtdedness back into cash which can be used to buy additional replacement property.

The IRS requires that all properties involved in your exchange need to be 'like'kind', correct? Well, when you change the vesting on your replacement property during the middle of an exchange, you are creating an opportunity for the IRS to question the 'held for' requirement and challenge your qualififcation of owning the new property as a different entity.

This is why you should always buy as the same entity in which you sold. Once the replacement property has closed, you can go ahead and approach your replacement property vesting and consider a change. But, unless you are simply acquiring the new property as a disregarded entiry for tax purposes, don't change vesting in the middle of a 1031 exchange.

The Internal Revenue Service specifically excepted partnership interests and LLC interests for qualifying for deferred gain treatment pursuant to IRS Section 1031. They did this because when you own an interest in either an LLC or a partnership, your ownership interest is in the entity, not the underlying property.

Therefore, if it is your intention to complete an exchange with your interest, you’ll need to have your interest divested from the entity and back into your name. This will then create a situation, where you may be able to exchange, assuming you’ve seasoned the new ownership in your name for a sufficient period to meet the “like-kind” requirement set for by the IRS in Section 1031.

“Drop and Swap” and “Swap and Drop” are terms of art used within 1031 exchange circles to describe the process of dropping out of a partnership or membership interest of a limited liability company (LLC) for the purposes of streamlining a 1031 exchange. Typically, the way a Drop and Swap is initiated is to drop out of the LLC interest and into an undivided tenant in common interest in the underlying property owned by the LLC (the drop) before 1031 exchanging (the swap) into a new investment property.

Once again, the reason the Drop and Swap is necessary is because LLC interests do not qualify to be exchanged pursuant to Section 1031 of the Internal Revenue Code. Therefore, prior to a sale an investor needs to have his interest in the LLC converted into an undivided interest that be successfully 1031 exchanged so the resulting capital gain taxes can be deferred.

There are several scenarios in which a Drop and Swap is both applicable and necessary, but the most common applies to a multiple member LLC. This is a very common form of ownership in which the entity typically has its own tax identification number and files its own tax return. Usually, the income and expenses are ratably distributed to the owners of the partnership on an IRS form K-1.

But imagine, when it is time to sell, what if some members want to 1031 exchange and others do not? What does an individual who wants to exchange do? The answer? Drop out of the LLC and into an interest which can be exchanged.

Let’s create an example. Let us assume that two individuals own an investment property equally in an LLC, 50/50. When it is time to sell, one wants to exchange and the other simply wants to pay his tax. What do they do? They wind down the LLC and distribute the interests ratably into their individual names. This is the drop. Then the one investor wanting to exchange (the swap) may, while the other simply sells and pays his tax.

Can a Drop and Swap create risk? Absolutely! Any time you are manipulating your vesting prior to anticipating an exchange you are creating liability with both the federal and state authorities. This is why when you are changing from one form of ownership to another, it is critical that you seek out good legal and tax assistance.

Don’t attempt a Drop and Swap on your own! But that said, it is a great strategy when implemented correctly and the Drop and Swap has saved billions of dollars in capital gain taxes over the years.

Need a referral for a legal professional who will make your Drop and Swap painless, let us know and we’ll refer a great solution.