useful 1031 exchange Terms
Below is a list of terms and concepts commonly used during the 1031 exchange process.
Adjusted basis. Generally, the adjusted basis of a property equals the purchase price, plus capital improvements, less depreciation. Transactions involving exchanges, gifts, probates and trust distributions may impact the property’s adjusted basis. An exchangor should consult independent legal counsel or tax counsel to determine a property’s adjusted basis.
Basis. Generally, this is the cost of the relinquished property and is the starting point for determining the gain/loss in a transaction involving the property.
Boot. In a 1031 exchange, boot is any consideration received by the exchangor other than real property, or property that is not “like-kind.” The exchangor pays taxes on boot (i.e., recognizes) to the extent of realized gain. Generally, there are two kinds of boot:
Cash boot: cash or anything else of value the exchangor receives as a result of the exchange.
Mortgage boot: any relief from debt the exchangor receives as a result of the exchange.
Buyer. The party that acquires the relinquished property from the exchangor.
Capital gain. The difference between the sales price of the relinquished property less selling expenses and the adjusted basis of the property.
Constructive receipt. The key issue in a 1031 exchange is whether the exchangor has any control over, or if the exchangor is in “constructive receipt” of, the funds from the sale of the relinquished property during the exchange period. The exchangor will be in constructive receipt of the exchange funds if the funds are credited to the exchangor, set aside for or otherwise made available so that the exchangor may draw upon the funds an any time or at any time the exchangor gives notice of their intention to draw upon them. In addition, the exchangor may not pledge, borrow or otherwise hypothecate the exchange funds, and actual or constructive receipt of the funds by an agent of the exchangor is deemed to be actual or constructive receipt by the exchangor.
Deferral. The capital gains tax on a 1031 exchange transaction is not paid at the time the exchangor sells the relinquished property. Rather, it is paid at the time the exchangor sells the replacement property, assuming that property is not later sold as part of another 1031 exchange. The basis of the relinquished property is carried over to the replacement property, making any necessary adjustments for additional consideration paid.
Direct deeding. Direct deeding occurs when title to the (1) relinquished property is conveyed directly from the exchangor to the buyer without an intervening deed to the qualified intermediary and (2) replacement property is conveyed directly from the seller to the exchangor without an intervening deed to the qualified intermediary.
Exchange Accommodation Titleholder (EAT). The entity that holds title to either the relinquished property or the replacement property in connection with a reverse 1031 exchange or holds the replacement property in an improvement exchange. The use of an EAT usually requires a QEAA to be executed between the exchangor and the EAT within five business days after title to property is conveyed to the EAT. In most cases, the EAT is affiliated with the qualified intermediary handling the exchange.
Exchange period. The time during which the exchangor must acquire the replacement property in a forward exchange or the time during which the exchangor must dispose of the relinquished/replacement property in a reverse exchange. In a forward exchange, the exchange period starts on the day the exchangor disposes of the relinquished property and ends on the earlier of the 180th day thereafter or the due date of the exchangor’s tax return for the year of the disposition of the relinquished property. In a reverse exchange, the exchange period starts on the day the EAT acquires the property and ends 180 calendar days thereafter.
Exchangor. The person or entity executing the 1031 exchange and receiving the potential tax benefits. Same as taxpayer.
IRC Section 1031. The section of the Internal Revenue Code that lays out the rules and regulations relating to 1031 exchanges and the potential nonrecognition of capital gain taxes.
Identification period. The period during which the exchangor must identify – in writing – the replacement property in the 1031 exchange. The identification period starts on the day the exchangor disposes of the first relinquished property and ends at midnight on the 45th day thereafter. There are three key rules that apply to the identification of the replacement property:
Three-Property Rule: The exchangor may identify up to three like-kind replacement properties without regard to the fair market values of the properties.
200% Rule: The exchangor may identify as many like-kind replacement properties as it wishes, provided the total aggregate fair market value of all properties identified does not exceed 200% of the sales price of the relinquished property.
95% Exception: The exchangor may identify any number of like-kind replacement properties without regard to the aggregate fair market value of the identified properties, as long as the replacement properties actually acquired amount to at least 95% of the fair market value of all identified properties.
Like-kind property. Under Section 1031, all real property (as defined by state law) is considered "like-kind" with other real property of the same nature or character, as long as each property is held for investment or for productive use in a trade or business. The term does not refer to a property’s grade, class or quality.
The following are examples of qualified “like-kind” real property exchanges:
Leasehold interest of 30 years or more for a fee interest
Conservation easement in one farm for fee interest in another farm
Rental house for farmland
Utility easement for a utility easement
Retail space for motel/hotel
Single family rental for multi-family rental
Farms/ranch for golf course
Raw land for rental property
Improved real property for unimproved real property
Commercial building for a ranch or farm
Qualified exchange accommodation agreement (QEAA). A written agreement between the EAT and exchangor executed within five days after title to the replacement/relinquished property is transferred to the EAT, whereby the EAT agrees to purchase and hold title to the replacement/ relinquished property in a reverse or improvement exchange, subject to certain terms and conditions.
Qualified intermediary. Please click here.
Relinquished property. The property that the exchangor owns at the beginning of a 1031 exchange and the property that the exchangor disposes of in the exchange.
Replacement property. The property that the exchangor intends to acquire in a 1031 exchange and the property that the exchangor owns at the end of the exchange.
Reverse exchange. A reverse exchange occurs when the exchangor identifies the replacement property prior to identifying the relinquished property. An EAT must be used to accomplish a reverse exchange, as the EAT is required to hold title to either the relinquished property or the replacement property pending the completion of the exchange.
Seller. The party that owns the replacement property that the exchangor wishes to acquire.
Taxpayer. The party that is performing the 1031 exchange and will receive the deferral of capital gains taxes on the sale.