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Using the 1031 Tax Exchange to Buy Hunting Land
Working with the Intermediary
You empower the intermediary to receive the proceeds from your sale and further instruct the intermediary as to which property you want to purchase as the replacement. The intermediary then makes the purchase (or purchases) on your behalf and finally signs the purchased property (or properties) over to you after the closing.
In exchange for this service, you pay the intermediary a fee. I'm sure it depends on your market and the nature of your transaction, but in my experience the intermediary receives well under $1,000 for a simple exchange.
Typically, a lawyer handles most of my transactions. He finds another attorney in the area that he is comfortable with to act as the intermediary. There are also hundreds of specialized companies set up to serve as intermediaries throughout the country. The intermediary doesn't have to be a local entity to handle this service for you. If you type "1031 tax exchange" into your internet search engine, you will quickly see that you have many options.
You must notify your buyer and seller that you are going to perform a 1031 tax exchange because they have to sign off on the exchange. They are effectively acknowledging that you have empowered an intermediary to act on your behalf in these transactions. You typically make this notification in the purchase agreement so the buyer and seller are bound by law to cooperate.
If you plan to execute a 1031 exchange, or think you might, be sure to add the appropriate language to any purchase agreement you enter into regarding the relinquished property and the replacement property.
You have 45 days starting the day after you close on the sale of your relinquished property to identify its replacement. If you don't notify the intermediary of the replacement within this time, the 1031 exchange will fail and you will immediately trigger the transfer of your assets into your name and you will be responsible for any taxes that result from the sale. Further, you have 180 days starting the day after your closing on the relinquished property to close on its replacement.
You can identify more than one replacement property. Certain rules apply if you identify more than three, so be sure to consult with your intermediary if you are considering identifying four or more properties.
The exchange has to take place within a single tax year. You may be able to play some games with filing dates to make that work, so consult with your tax accountant if you are at risk.
Types of Exchanges
There are several types of 1031 tax exchanges. I have detailed them below.
The most common type of 1031 exchange used is the delayed exchange. This is the type that I have discussed so far, where you sell the relinquished property first and then purchase the replacement property.
For an exchange to be a simultaneous exchange, both closings must occur at the same moment - the closing for your sale and the closing for your purchase. Again, this satisfies the requirement that you have no actual or constructive receipt of the funds of the sale of the relinquished property before purchasing the replacement. At one time, this was how all exchanges were done, but today, simultaneous exchanges are rarely used.
Improvement exchange or construction exchange
Construction exchanges permit you to make improvements on the replacement property before assuming ownership. To do this, the intermediary makes the improvements before signing the property over to you. For example, suppose you sell a parcel of land near the city worth $300,000. Your goal is to use the proceeds to buy a piece of hunting land and put a cabin on it. You can defer all the capital gains taxes on your sale as long as the replacement property, plus the improvements (the cabin), are worth at least $300,000.
Reverse exchanges are the most complex. In this scenario, you buy the replacement property before relinquishing the original property. Again, you can't hold title to both at the same time. An Exchange Accommodation Titleholder makes the purchase and holds the title of the replacement property on your behalf and this starts the clock ticking. You have 45 days from that closing to identify the relinquished property and 180 days to close the sale of the relinquished property.
Obviously, identifying the relinquished property is easy, but closing it in 180 days may not be so easy unless you already have a buyer on the hook.
You don't have to use every dollar of the proceeds from the sale of your relinquished property to purchase a replacement property. If you use only a portion, the taxable gains are pro-rated accordingly. If you perform a partial exchange, the amount of money remaining after the replacement property is purchased is called cash boot.
When performing an exchange where the relinquished property is under mortgage, you still have to replace the entire sale price of the relinquished property (not just your equity) or the IRS will treat it as a partial exchange. You can replace the debt with cash or new debt to defer all capital gains taxes. However, if you don't, you will have what is called mortgage boot, which will incur a tax liability.
The 1031 tax exchange is a powerful tool for those looking to upgrade to their dream hunting land, which should be a big part of your long-term strategy.