1031 Exchange—An exchange permits a taxpayer to reinvest the proceeds from the sale of property held for investment or used in a business into another investment or business property and defer capital gain tax that would otherwise be due on the initial sale.
Adjusted Basis—The original basis at time of purchase plus improvement costs minus depreciation taken.
Boot—Non-like-kind property received during the exchange by the exchanger. Boot does not qualify for non-recognition treatment. Cash is the most common form of boot, but debt relief also constitutes boot. Boot is subject to taxation.
Capital Gain—Basic capital gain calculations are as follows: total selling price of the relinquished property, less exchange expenses, less the relinquished property's adjusted basis. The adjusted basis is the original cost, plus the cost of capital improvements, less depreciation or other cost recovery deductions. Improved property is generally subject to recapture of depreciation in addition to capital gain tax.
Construction Exchange—An exchanger may wish to construct new property as his replacement property. Provided that the improvements are completed prior to the expiration of the exchange period, this may be done. In a construction exchange, the property is held by a specially formed LLC called the Exchange Accommodation Titleholder (EAT) during the construction period. A construction exchange involves greater complexity and higher fees than a standard exchange. With 30 years of construction experience, Iowa Equity Exchange is well-positioned to handle construction exchanges.
Constructive Receipt—The exchanger must not violate the constructive receipt clause of Section 1031 or the exchange will fail. To avoid constructive receipt, neither the taxpayer nor his agent may have control of any part of the proceeds of the relinquished property sale.
Cooperation Clause—A provision in a purchase agreement that states that one or both of the parties to the agreement intends to conduct a 1031 exchange and reserves the right to assign its interest in the purchase agreement to a Qualified Intermediary. A cooperation clause also typically requests the other party to assist by signing necessary 1031 documents. Such language generally discloses that there will be no additional expense to the cooperating party. A cooperation clause is not specifically required in Section 1031 regulations, but it is generally a good idea to include.
Delayed Exchange—A delayed exchange, also known as a forward exchange, a Starker exchange, a like-kind exchange, a tax-deferred exchange, etc., is the most common type of exchange.
Disqualified Person—Section 1031(k)-1(k) defines a disqualified person as an agent of the taxpayer at the time of the transaction and state that such a person may not function as the intermediary in an exchange. Anyone who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within two years of the transfer of the relinquished property is considered the taxpayer's agent. In addition, there are specific rules that disallow the use of a relative or a related party in an exchange.
Direct Deeding—At the direction of the Qualified Intermediary, title passes directly to the new purchaser of property without the QI being in the chain of title.
Exchange Accommodation Titleholder—The Exchange Accommodation Titleholder (EAT) is a single-purpose LLC formed by the Qualified Intermediary for use during a Construction, Improvement, or Reverse Exchange.
Exchanger—The entity that owns the investment property or business property to be exchanged. The entity can be an individual or married couple, an LLC, a corporation, a partnership, a trust, etc. Other terms for Exchanger are Taxpayer, Investor, or Client.
Exchange Account—The account established by the Qualified Intermediary to hold the exchange funds. As an exchanger, it is critical that you determine that your Qualified Intermediary hold your funds in an insured account in a form that is 100% liquid at all times. At Iowa Equity Exchange, all exchange accounts are strictly segregated from other exchange accounts, are held in FDIC-insured money market accounts, and are 100% liquid at all times.
Exchange Period—The 180-day window allowed by Section 1031 regulations for the completion of a tax-deferred exchange.
Fair Market Value—What a willing buyer would pay to a willing seller in an arms-length transaction.
Identification Period—The time period allowed by Section 1031 regulations for an exchanger to properly identify potential replacement properties. This time period is defined as 45 calendar days beginning with the date of closing of the relinquished property.
Identification Rules—The exchanger must choose one of three rules when identifying potential replacement properties:
- Three-Property Rule—The exchanger may identify up to three properties, regardless of their individual values or their value in the aggregate.
- 200% Rule—The exchanger may identify any number of properties provided their combined fair market value does not exceed 200% of the value of the relinquished property.
- 95% Exception—The exchanger may identify any number of properties without regard to their value, provided that the exchanger acquires at least 95% of the fair market value of the properties identified.
IRS Section 1031—The basis for the tax-deferred exchange states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment."
Like-Kind Property (Real Estate)—The properties involved in a tax-deferred exchange must be similar in nature or characteristics. The definition of "like kind" as it pertains to real property is very broad. If the property has been held for productive use in a business or trade or for investment, it is like kind to other property that, when acquired, the exchanger intends to hold for productive use in a business or trade or for investment .
Like-Kind Property (Personal Property/Business Assets)—Non-real business or investment property is also eligible for non-recognition treatment through Section 1031. The like-kind rules are much more restrictive on the exchange of personal property/business assets. Property must be exchanged within asset classes or product classes.
Napkin Rule—A somewhat antiquated term, but still occasionally used. The term relates to what needs to be done to defer the maximum amount of tax in an exchange: 1) a replacement property of equal or greater value to the relinquished property must be purchased, 2) debt on the replacement property must be equal to or greater than that of the debt paid off on the relinquished property, and 3) all of the cash proceeds from the sale of the relinquished property must be invested in the replacement property.
Original Basis—The purchase price of a property. Basis is used to calculate capital gains or losses for tax purposes.
Phase 1 (a.k.a. First Leg, Down Leg)—The process during which the relinquished property is sold and the relevant paperwork for that process and the exchange is completed.
Phase 2 (a.k.a. Second Leg, Up Leg)—The process during which the replacement property is purchased and the relevant paperwork for that process and the exchange is completed.
Purchase Agreement—The legally-binding written agreement for the purchase and sale of real property. Other terms meaning the same things are Agreement for Transfer, Sale Agreement, Earnest Money Agreement, Offer and Acceptance, and Real Estate Contract.
Qualified Intermediary—The party that facilitates the exchange. Interchangeable with Intermediary, QI, accommodator, facilitator, qualified escrow holder. Section 1.1031(k)-1(g)(4)(iii) requires the QI to enter into a written Exchange Agreement with the exchanger and, as required by the Exchange Agreement, acquire the relinquished property from the exchanger, transfer the relinquished property to the buyer, acquire the replacement property, and transfer the replacement property to the exchanger.
Relinquished Property—The property being sold by the exchanger in an exchange.
Replacement Property—The property being acquired by the exchanger in an exchange.
Reverse Exchange—A reverse exchange is typically conducted under the Safe Harbor established in Rev Proc 2000-37. A reverse exchange can be accomplished under this safe harbor in one of two manners:
- The EAT purchases and "parks" the replacement property for the benefit of the exchanger until such time as the exchanger sells the relinquished property, or
- The EAT purchases and "parks" a relinquished property for the benefit of the exchanger, who immediately acquires the replacement property. The EAT later transfers the relinquished property to the ultimate buyer.
Settlement Agent—The party responsible for the actual closing of a transaction. Other terms in use include title agent, closing officer, escrow officer, settlement officer, closing agent, closing attorney, and settlement attorney.
Tax Advisor—Accountant, CPA, financial advisor, tax attorney.
Tenancy in Common (TIC)—A fractional ownership interest in real estate.
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