<h2>Mixed-Use 1031 Exchanges</h2>

<p>A mixed-use exchange transaction occurs when a taxpayer sells property that includes their “primary personal residence,” and other land, structures, and other improvements used in a trade or business or held as an investment.</p>

<p>Some practical examples are:</p>

<ol>
<li>A home office where a business pays the taxpayer rent for office space within the principal residence;</li>
<li>Farm and ranch land where the taxpayer works the land as their business, but lives in their principal residence also located on the property;</li>
<li>A duplex where the taxpayer lives in one unit as their principal residence and rents the other unit; and</li>
<li>A single family home with an accessory dwelling unit (“ADU”), attached or detached, and the taxpayer lives in the home as their principal residence and rents out the ADU.</li>
</ol>

<p>The list is extensive, but mixed-use exchanges appear when there is a principal residence, commonly referred to as primary residence, on or within the land or building being conveyed as part of one transaction.</p>

<p>As a recap, Internal Revenue Code Section 1031(a)(1) provides: “In general no gain or loss shall be recognized on the exchange of property <em><a href="/blog/irc-section-1031-exchange-qualified-use-requirements" title="Qualified Use Requirements">held for productive use in a trade or business or for investment</a> </em>if such property is exchanged solely for property of like-kind which is to be held either for<em> productive use in a trade or business or for investment.</em>” This section of the tax code is a tool to defer gains.</p>

<p>Another provision in the code, Section 121, provides that a taxpayer, “regardless of age, may exclude up to $250,000 ($500,000 for married persons filing jointly) of gain on the sale or exchange of his or her primary residence if, during the five-year period ending on the date of the sale or exchange, the property has been owned by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more.” Unlike IRC Section 1031, IRC Section 121 excludes capital gain taxes on the sale rather than deferring the tax with no strings attached to how the taxpayer reinvest their sale proceeds.</p>

<p>So, <a href="/blog/1031-exchange-rules-vacation-homes-primary-residences-and-mixed-use-properties" title="1031 exchange for primary residence and vacation homes">how does a taxpayer take advantage of both sections of the tax code at the same time</a>? First, it’s important to identify your principal residence. A principal residence is not the taxpayer’s second home or vacation home which do not get the Section 121 benefit.</p>

<p>A principal residence is typically a taxpayer’s registered voting address, primary mailing address on your tax return, and other business documents, and the address on your driver’s licenses. As explained above, the principal residence may be part of a business use or investment property.</p>

<h2>Here are some frequently asked questions about the interplay between Section 1031 and Section 121:</h2>

<p>&nbsp;</p>

<h3>How is the exclusion amount calculated under IRC Section 121?</h3>

<p>Simply consider the original purchase price of the residential portion of the property and the cost of any improvements made to the residence, which is the adjusted basis. Next determine the value of that portion of the property that comprises the residence which is generally a reasonable area that is enjoyed in conjunction with the home. If the taxpayer desires some proof of value, a current market analysis may be obtained from a Realtor® and there are other considerations discussed below. A formal appraisal is another way to substantiate the valuation.</p>

<p>To determine the exclusion amount, the taxpayer will find out if they file their taxes jointly or singly. Single filers can exclude the basis plus an additional $250,000. Joint filers can exclude the basis plus an additional $500,000. The resulting amount is simply cash in the taxpayer’s pocket.</p>

<p>Commonly, taxpayers find themselves with one purchase and sale contract containing both personal residence and 1031 real property with no specific allocation of value to the personal residence. Valuing the residential portion separately is arguably more art than science. The Current Market Analysis mentioned above is one approach. Some value considerations when making the analysis are: (1) the per acre value for a defined small parcel rural residential homesite being greater than per acre value for the much larger farm or ranch acreage; (2) homeowners insurance valuation for the primary residence possibly (3) the current taxable assessed value; and (4) the valuation of other amenities with the homesite that are part of the taxpayer’s enjoyment of the home. This is not an exhaustive list, and taxpayers are encouraged to consult their CPA or tax attorney for additional guidance.</p>

<h3>How is the homesite defined in the context of the larger property being sold?</h3>

<p>Aerial photos are a great resource in determining the reasonable configuration of the homesite. It’s reasonable to conclude that the principal residence is comprised of not only the house, but well, septic and drain field, landscaping, shelterbelts, ponds, small pastures associated with pets and horses, and any other features that lend to the enjoyment of the residence. Those features can become quite evident from aerial photos.</p>

<p>The resulting analysis of value is a valuable document to be included in the taxpayer’s file as part of the transaction. The taxpayer and their advisors can rely on this resource to not only arrive at the exclusion amount but can reference it from the file if the excluded amount is ever be questioned by the IRS.</p>

<p>Consider this simple hypothetical:</p>

<ul>
<li>Total sale price $2,500,000</li>
<li>Principal residence valuation $800,000</li>
<li>Joint filing taxpayer’ basis in principal residence $300,000</li>
<li>Tax free cash to taxpayers $800,000.00</li>
<li>Section 1031 portion of the transaction $1,700,000</li>
</ul>

<h3>How can the 121 exclusion be used in the context of a property sale with debt payoff?</h3>

<p>The 121 exclusion can provide benefits in addition to putting tax free cash in the taxpayer’s pocket. Assume the property sale in the example above required debt payoff to a lender of $500,000. Normally the taxpayer would then be required to <a href="/blog/what-cash-boot-1031-exchange" title="Boot in a 1031 exchange">exchange equal or up in value</a> replacing $500,000 debt payoff with new debt or inserting new cash into the acquisition of the replacement property.</p>

<p>However, in our example, the taxpayer can allocate the debt payoff to the principal residence. That means the taxpayer doesn’t have to take on new debt or insert new cash into the replacement property acquisition and can retain the remaining $300,000 cash.</p>

<h3>How is the 121 exclusion documented at closing?</h3>

<p>Documenting the allocation of the sale proceeds partly to the personal residence exclusion and the 1031 exchange is relatively simple. The settlement statement for the relinquished property sale will contain a line item for “cash to exchanger (personal residence)” and a line item for “exchange proceeds to seller” which is the qualified intermediary.</p>

<h3>Are there other situations where the 121 exclusion does not apply?</h3>

<p>There are situations where the 121 exclusion cannot be used such as sales involving farms, ranches and other business properties which include the owners’ residences, but the entire property is owned by a corporation or partnership. Generally, the IRC Section 121 exclusion is available only to individuals, not S Corporations, C Corporations, or tax partnerships because these entities cannot own a principal residence. That said, <a href="/blog/same-taxpayer-requirement-1031-tax-deferred-exchange" title="Disregarded Entities in a 1031 exchange">business or other entities disregarded for tax purposes</a> (i.e. single- member limited liability companies, sole proprietorships, and grantor trusts) can use the Section 121 exclusion.</p>

<p>In the situations referenced above, it may be possible to distribute the personal residence on the ranch, farm, or other business property out of the entity prior to the sale and exchange. However, it is best to employ some advance planning to assure the distribution takes place at least two years before the sale.</p>

<p>To summarize, the Section 121 exclusion provides taxpayers with tax free cash and no reinvestment requirement. For the personal residence portion of a sale of business use property Taxpayers may also allocate the excluded amount to any debt payoff at sale and eliminate the debt replacement requirements for the 1031 portion of the transaction. There are also opportunities for taxpayers to acquire property in a 1031 exchange, hold the property for five years, live in a residence on the property for two of those five years and claim the Section 121 exclusion on the sale of the residential portion in a subsequent sale transaction.</p>

<p>Note, however, that when participating in a 1031 exchange, the taxpayer’s intent with regard to the replacement property should be that it will be “held for productive use in a trade or business, or for investment” indefinitely. Taxpayers are encouraged to seek the guidance of tax and legal counsel when structuring 1031 exchanges, or when considering changing the character of the investment property.</p>

<h2>The Facts</h2>

<p>Title Company ABC does the title work for several customers that utilize 1031 exchanges on their real estate transactions for properties held for investment and business use. Because Title Company ABC does not service 1031 exchanges, they must refer these customers out to a competitor that services 1031 exchanges, in addition to title work.</p>

<h2>The Problem</h2>

<p>As Title Company ABC continues to refer their customers executing 1031 exchanges out to their competitor, eventually, some of these customers moved all their business, including title work, over the competitor to simplify the process by keeping everything with one company.</p>

<p>Because Title Company ABC did not have the time or resources to start a Qualified Intermediary needed to service 1031 exchanges in house, they would continue to lose some customers to their competitors and lose present and future revenue – they needed to find a solution.</p>

<h2>The Solution: Managed Service by Exchange Manager Pro^SM</h2>

<p>Title Company ABC attended a recent Land Title convention held by their state association. While attending, they heard about Managed Service through Exchange Manager Pro^SM, a turnkey, white-label Qualified Intermediary solution.</p>

<p>Managed service would allow Title Company ABC to offer 1031 exchanges “in-house” under a custom branded Qualified Intermediary entity, while the Exchange Manager Pro^SM team of 1031 experts worked behind the scenes as the back-office facilitating the 1031 exchanges.</p>

<p>The unique nature of Managed Service will allow Title Company ABC to offer and monetize 1031 exchanges without needing to invest or divert scarce resources.</p>

<p>Title Company ABC decided to give Managed Service by Exchange Manager Pro^SM a try. For a nominal upfront set-up fee, they were onboarded as Managed Service clients within days, and they were able to start offering 1031 exchanges to their existing clientele.</p>

<h2>The Result</h2>

<p>Within a few short months of implementing Managed Service, Title Company ABC has earned roughly $20,000 of new income from the revenue share which is made up of both shared fee and deposit revenue. Additionally, they were able to retain roughly 10 customers that they would have previously referred out to a competitor, and they were able to secure a handful of new customers that were looking for a title company that offered both 1031 exchange and title services under the same roof.</p>

<p>Does this scenario sound familiar? If so, <a href="/managed-service" title="Managed Service by Exchange Manager Pro">visit to learn more about Managed Service</a> and how it could benefit your company.</p>

<p>Previously, I discussed section 1031(f) of the Internal Revenue Code, <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">the Related Party Rules</a>, introduced by Congress in 1989 to prevent taxpayers from manipulating the 1031 exchange rules to achieve a favorable outcome by entering into an exchange with a party related to them.</p>

<p>1031(f), added “special rules for exchanges between related persons” and essentially provided that such related party exchanges would not be allowed when, ”before the date 2 years after the date of the last transfer which was part of such exchange—</p>

<p style="margin-left:.5in;">(i) the related person disposes of such property, or</p>

<p style="margin-left:.5in;">(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer”</p>

<p>We looked at the abuse that gave rise to the Related Party Rules and at which relationships are considered related parties. This week, we’ll examine common misconceptions of and exceptions to the Related Party Rules.</p>

<h2>Common Misconceptions</h2>

<h3>I can get around the Related Party rules using a Qualified Intermediary.</h3>

<p>Transacting an exchange through a Qualified Intermediary (QI) who is not a party related to the taxpayer does not “cleanse” the transaction when the seller is a related party. If the QI acquires the property from a party related to the taxpayer, the abuse is present, just as it would be if the taxpayer traded directly with the related party.&nbsp; The catch-all provisions of §1031(f)(4) make clear that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”&nbsp; Simply acquiring the related party’s property through the unrelated QI does not change the outcome. The IRS position on this scenario was the subject of <a href="http://www.irs.gov/pub/irs-drop/rr-02-83.pdf&quot; target="_blank">Revenue Ruling 2002-83</a>.</p>

<h3>I looked it up and discovered it’s ok as long as I hold the replacement property for two years.</h3>

<p>Many people, including professional advisers, see the two year holding exception to the application of the related party rules and believe that, should the taxpayer acquire replacement property from a related party and hold the property for at least two years, the prohibition is nullified.&nbsp; Unfortunately, this exception only applies if <u>both</u> the taxpayer and the related party hold the respective properties received in the exchange with one another for a minimum of two years.&nbsp;</p>

<p>In a more typical related party scenario, the taxpayer’s relinquished property is sold to a third party and the replacement property acquired from a related party.&nbsp; Since they are not exchanging with one another, the exception by its terms does not apply.&nbsp; The related party cannot hold the taxpayer’s relinquished property since that property was transferred to a third party buyer. &nbsp;Only in the very narrow instance in which two related parties are exchanging with one another and they each hold the properties for two years or more does this exception apply.</p>

<h2>Are there any other exceptions to Related Party Rules?</h2>

<p>As indicated above, the two year holding exception has limited applicability, applying only to exchanges between taxpayers who receive (and hold) each other’s property. Under this exception, if the properties are held for a minimum of two years, there is a presumption that the trade was motivated by reasons other than “abusive basis shifting.”</p>

<p>Another exception, under Section §1031(f)(2)(C), provides for an earlier than two year disposition of a property that is part of a related party transaction. This section states that the transaction will not be disqualified if, “with respect to which it is established to the satisfaction of the [Treasury] Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”&nbsp; Most exchanges involve tax deferral so it is difficult to make this case.&nbsp; There have, however, been favorable IRS rulings in which family members exchanged undivided interests in several properties in order to allow each to own a whole. This is a perfect example of this exception.</p>

<p>An additional exception is based upon a series of private letter rulings beginning with <a href="http://www.irs.gov/pub/irs-wd/1220012.pdf&quot; target="_blank">PLR 201220012</a> which pertained to a taxpayer’s disposal of replacement property within the two year period.&nbsp; The ruling concluded since the related party did an exchange from that property into another, there was no cashing out and therefore no tax abuse.</p>

<p>Finally, a seldom-used exception to the requirement of both parties retaining the property for two years or more occurs in the event of the death of the taxpayer or the related person.&nbsp; Such an event will allow for the exchanged property being sold within the two year period while maintaining the original deferral.&nbsp; Taxpayers will do just about anything to avoid paying tax, but this is clearly not a strategy that anyone will want to employ.</p>

<h2>Summary</h2>

<p>The exceptions to the prohibitions of the Related Party Rules have in common the notion that the involvement of the related party is attributable to reasons other than allowing the taxpayer to cash out while selling a low basis property to a third party. Learn more about 1031 Related Party Rules in my original post, <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">1031 Tax Deferred Exchanges Between Related Parties</a>.</p>

<p>&nbsp;</p>

<p><em>Updated 7/20/2022.</em></p>

<h2>Passive Real Estate Investments for Replacement Property</h2>

<p>When traditional replacement property is hard to come by many taxpayers look toward passive investment options to complete their 1031 exchange. Some common examples of passive replacement property options in 1031 exchanges include:</p>

<h3>DSTs (Delaware Statutory Trusts)</h3>

<p>A DST is a real estate investment vehicle that provides investors with access to investment grade real estate that is generally larger than they could have acquired on their own. Through a DST the Taxpayer acquires a fractional interest in a property equal to the Taxpayer’s equity investment.</p>

<p>DSTs allow for diversification of a real estate investment portfolio and eliminate the headaches involved in traditional real estate ownership, the so-called “Three-Ts: Toilets, Tenants and Trash”. DSTs are increasingly popular with seasoned real estate investors that are looking to change their active real estate investment into passive real estate investments, allowing them to retire from property management responsibilities.</p>

<p>This type of investment is intended to provide reliable income with no property management. Also, when the property as a whole is sold (5-7 years typically) the investor also shares pro rata in the increased value, in addition to the quarterly income having been received along the way.</p>

<h3>Passive Ownership Through 3rd Party</h3>

<p>For taxpayers that want traditional ownership of real property with all of the benefits that come with passive investments, Doorvest provides the perfect solution.</p>

<p><a href="https://bit.ly/3ahvlfY&quot; title="Doorvest">Doorvest</a> facilitates the purchase of an investment home remotely and helps the taxpayer generate passive income from day one of closing. They also manage the property, making owning rentals much easier and you still have full ownership of the rental home. Doorvest also allows you to acquire replacement property anywhere in the <a href="https://bit.ly/3bU3mTI&quot; title="Doorvest Markets">following markets</a>, entirely online so your property options are more expansive than just your local market.</p>

<p><a href="https://bit.ly/3yKx3j3&quot; title="Experience the Doorvest Experience">Experience the Doorvest Process</a></p>

<h2>Consider a Different Type of Exchange</h2>

<p>The other solutions available if you are facing difficultly finding replacement property is to structure your exchange as either a Reverse Exchange, also known as Parking Exchange or as an Improvement or Build-to-Suit Exchange, also known as a Construction Exchange.</p>

<h3>Reverse Exchanges</h3>

<p>In situations where the taxpayer wishes to acquire their replacement property prior to the sale of their relinquished property, to ensure they do not lose out on the replacement property, a Reverse Exchange is recommended.</p>

<p><a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">Learn more about the Reverse Exchange process. </a></p>

<h3>Build-to-Suit or Improvement Exchanges</h3>

<p>Build-to-Suit, also known as Construction-to-Suit or Improvement Exchanges allow the taxpayer to put exchange funds toward the cost of improvement to the replacement property. These types of exchanges provide the taxpayer with more options for their replacement property because they can use the funds to turn the property into the right fit, they don't have to find the perfect fit as-is.</p>

<p><a href="/blog/can-property-improvement-costs-be-part-1031-tax-deferred-exchange">Learn more about Build-to-Suit/Improvement Exchanges.</a></p>

<p>Whether you decide to identify passive investments for your replacement property or decide on one of the other types of 1031 exchanges, these available solutions will help you successfully complete your 1031 exchange in even the toughest real estate markets.</p>

<h2>US Real Estate Ownership Among Foreign Citizens</h2>

<p>According to the Congressional Research Service, foreign citizens own 3% of all US real estate, with investors from Canada, Netherlands, and Italy accounting for about half of that. As of 2019, the states with the highest number of foreign-owned acres were Texas (4.4 million acres), Maine (3.3 million acres), Alabama (1.8 million acres), and Washington and Colorado (1.5 million acres each). Arkansas, California, Florida, Georgia, Louisiana, Michigan, New Mexico, Oklahoma, and Oregon each report approximately 1 million acres owned by foreign citizens. What happens when these foreign owners want to sell their US real estate?</p>

<h2>What is FIRPTA?</h2>

<p>The disposition of any interest in US real property by a foreign taxpayer is subject to the Foreign Investment in Real Property Tax Act of 1980, commonly known as FIRPTA, income tax withholding. In short, what this means for the foreign seller of a US Real Property Interest is that the buyer of that interest must withhold 15% of the purchase price at the time of the sale. This applies to all transfers by foreign taxpayers – whether by sale, exchange, liquidation, redemption, gift, or otherwise. The recipient of the property – the buyer, transferee, purchasers’ agents, and settlement officers are tasked with holding back 15% of the purchase price, rather than paying it directly to the foreigner investor. If the transferor were a foreign taxpayer, and you, as the Buyer or settlement officer, fail to withhold those funds, you could be held liable for the tax.</p>

<p>FIRPTA withholding does include exceptions to the withholding rules. As applied to 1031 exchanges, the most relevant exceptions that allow you to disregard FIRPTA include:</p>

<ul>
<li>You (the Buyer) are going to be using the property as your principal residence, and the fair market value is less than $300,000</li>
<li>The Seller provides you with a Certificate of Non-Foreign Status (meaning that FIRPTA does not apply)</li>
<li>If the foreign Seller obtains a FIRPTA Withholding Certificate by filing <a href="https://www.irs.gov/pub/irs-pdf/f8288b.pdf&quot; title="IRS Form 8288B">Form 8288-B</a>.</li>
</ul>

<p>It is important to note that the foreign Seller cannot submit the Form 8288-B until there is a valid real estate contract. The completed form should be submitted to the IRS promptly, and before the actual closing date on the sale. Any form submitted after the closing date will be deemed by the IRS to be untimely and require that the mandatory withholding amount be sent to the IRS within 20 days of the closing date.</p>

<p>As a practical matter, all of this has two key impacts:</p>

<ul>
<li>1031 exchange Buyer of a foreign person’s real estate – As the 1031 exchange Buyer of a foreign person’s real estate, you would be required to withhold 15% of the fair market value of the real estate, typically the purchase price, at the time of closing. More often than not, this task is completed by the settlement agent or escrow agent, but a prudent buyer would ensure compliance.</li>
<li>Foreign investor selling as part of a 1031 exchange – When the foreign investor is selling as part of a 1031 exchange, that investor is advised to submit Form 8288-B as soon as they have a contract for the sale of that property. If the 8288-B is not submitted before closing, the Buyer will be required to withhold, and to then remit, the 15% to the IRS by the 20th day after closing. It typically takes the IRS up to 90 days to process requests for refunds or exemptions using Form 8288-B.</li>
</ul>

<p>Buyers, closing agents, and Qualified Intermediaries such as Accruit are required to comply with FIRPTA withholdings. Whether you are a 1031 exchange buyer of a replacement property from a foreign taxpayer, or you are a foreign investor selling as part of a 1031 exchange, you should consult with your tax or legal advisors well in advance of the closing.</p>

<h2>Simultaneous Exchange</h2>

<p>Many people are surprised to learn that Section 1031 first made its way into the tax code in 1921. This was based on a belief by Congress that when someone swaps property with someone else and takes no cash out of the deal, there is no basis for assessing a tax. So, if a farmer traded some farmland with another for equal value, at the end of the day, each ended up with essentially what he had before.&nbsp; This was considered a continuity of investment. It wasn’t relevant what each paid originally for his property (the property basis). Since the properties were not usually of equal value, some cash was usually necessary to equalize values. Then, as well as now, the receipt of the cash was not the receipt of “like-kind property” and therefore subject to tax. These exchanges took place directly between two persons, and the property exchanges were simultaneous.</p>

<h2>Three-Party Exchanges</h2>

<p>Over time, the two-party direct exchange became expanded a bit in order to provide greater opportunity to complete an exchange. In the example above, imagine how infrequent it would be for the two parties to find one another and have the properties and values work out. However, by adding a third party, the opportunity to complete a 1031 exchange became much more viable. Essentially, the taxpayer would find a willing buyer, and rather than receiving property of the buyer’s in trade, the taxpayer found desirable property from a third-party seller. So if the taxpayer arranged to sell the relinquished property to the buyer for $100, the buyer would be directed instead to pay the $100 to acquire the other property from the seller and, in turn, to transfer the seller’s property to the taxpayer to complete the transaction. The taxpayer would have concluded an exchange, the buyer simply bought taxpayer’s property, and the seller simply sold his property and cashed out.</p>

<h2>Delayed or Deferred Exchange</h2>

<p>Simultaneous exchanges continued along until the late 1970s. At that time, a particular taxpayer’s advisors took another look at Section 1031 and concluded that the language did not explicitly require an exchange to be simultaneous in order to be valid. In one case, a three-party exchange was structured providing that the buyer would be obligated to acquire properties selected by the taxpayer during a five-year period to equalize the value of the property sold to the buyer up front. To the extent that properties were not chosen over that time frame to meet the necessary value, the buyer would pay the difference to the taxpayer at the end of the five-year period, and the taxpayer would pay tax on the receipt of that money. So an exchange structured like this involved a “delay” between the exchange events.&nbsp; It could also be said that the time for the taxpayer to receive the replacement property was “deferred” from the time of sale of the relinquished property, hence the term tax deferred exchange or 1031 tax deferred exchange. However, since the purpose of completing a 1031 exchange is to “defer” taxes, the reference to a deferred exchange can confuse the two different intentions regarding the use of the term “deferred.”</p>

<h2>The Starker Exchange/Starker Trust</h2>

<p>After an extensive legal battle between the taxpayer alluded to above and the IRS regarding the validity of a delayed time period (five years) to effectuate an exchange, the taxpayer prevailed in Federal District tax court. The taxpayer’s name was T.J. Starker. The decision in the case opened a huge window of opportunity for taxpayers to conclude exchanges on a delayed basis, but it opened up a myriad of accounting issues too. There were also practical issues like how to ensure that the buyer would, in fact, be ready, willing and able to buy the selected replacement property several years after receiving the relinquished property.</p>

<p>In response to the Starker case decision, Congress, as part of the Tax Reform Act of 1984, decided to tighten up the exchange period dramatically. So, a 45-day period to formally identify a potential replacement property and 180-day period to acquire it became an amendment to Section 1031. So, although Congress agreed that an exchange does not necessarily need to take place on a simultaneous basis, it did place restraints on the open-ended nature of the Starker decision.&nbsp;</p>

<p>Like any modern-day exchange, the taxpayer cannot receive or have any interest in the funds owed by the buyer for the purchase of taxpayer’s property; however, these funds are required to purchase the replacement property. In order to facilitate this, it was decided that any property would be put in trust for the benefit of the parties but out of the possession of either party. The trust would provide that the buyer’s funds would be used to purchase the replacement property and anything left over after 180 days would be paid directly to the seller/taxpayer (and tax would be paid on any such portion). What better idea than to call this a Starker Trust? Although the Starker Trust went away in 1991 as per the next section, to this day, many people still use the name of a “Starker exchange.”</p>

<h2>Tax Deferred Exchange (1031 Tax Deferred Exchange)</h2>

<p>The latter half of the 1980s witnessed a huge increase in Starker exchange activity. With the increase in activity more terms for a 1031 exchange were created which include tax deferred exchange, 1031 tax deferred exchange, and deferred 1031 exchange. However, other than Section 1031, IRS rulings and some legal decisions, there was a scant authority on how to properly do an exchange. In 1991, the Treasury Department issued <a href="/exchange-library/internal-revenue-service-regulations-irc-%C2%A71031">a comprehensive set of regulations</a> on the subject that still govern exchange procedures today.&nbsp; Although these regulations still approved the use of a trust, in most cases its not necessary. Perhaps the most significant aspect of the new regulations was the suggested use of an intermediary in order to fall into the safe harbor of these regulations. Use of the intermediary obviated the involvement of the buyer in the taxpayer’s exchange. The intermediary effectively took the place of the buyer in this regard. Essentially, the taxpayer would sell the relinquished property to the Intermediary who would cause the property to be transferred to the buyer. Later, the intermediary would acquire the replacement property on behalf of the taxpayer and cause it to be transferred to her. Although legal title could be transferred directly and did not need to pass through the intermediary, through the use of these provisions, for tax purposes the taxpayer was deemed to have concluded an exchange with the intermediary.&nbsp;</p>

<p>Under regulations, certain persons or entities, such as agents and employees of the taxpayer, were disqualified from acting as the intermediary.&nbsp; Anyone who was not disqualified was considered “qualified" and the present day exchange requires the use of a qualified Intermediary or “QI.”&nbsp; A secondary function allowed for the proceeds from the sale of the relinquished property to be held by the intermediary on behalf of the taxpayer to remove the buyer from any participation in the taxpayer’s exchange while also ensuring the taxpayer not be considered to have any dominion or control of those funds. Although the use of a trust was still approved by the regulations, in most situations the QI holding the funds replaced the need for the trust.</p>

<h2>Other common, yet misspoken terms for 1031 exchanges&nbsp;</h2>

<p>Some other common, yet incorrect terms that 1031 exchanges are often called include:&nbsp;</p>

<ul>
<li>Like Exchange, a misinterpretation of Like-Kind Exchange</li>
<li>10-31 Exchanges, an incorrect alteration to a 1031 Exchange namesake to the IRC Section 1031&nbsp;</li>
<li>Tax Deffered Exchange, a very common misspelling of "deferred"&nbsp;</li>
</ul>

<h2>Reverse Exchange</h2>

<p>In 1990, when the exchange regulations were under consideration by the IRS during a year-long comment period, many people asked the IRS to include rules for when a taxpayer needed to acquire, or face losing, a replacement property prior to the sale of the relinquished property. In other words, when the sequence of closings was “reverse” from normal. Although the 1991 regulations did not provide guidance on the subject, the IRS indicated that it would consider providing such rules in the future.&nbsp; In 2001, such rules were issued. Those regulations suggested several different ways for a taxpayer to effectively preserve the ability to <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">acquire the target replacement property prior to the sale of the relinquished property</a><span style="color:#0000cc">. </span>These techniques continue to be very popular to this day by way of a Reverse Exchange or Parking Exchange.&nbsp;</p>

<h2>Build-to-Suit/Improvement Exchanges</h2>

<p>Similar to the need for guidance regarding reverse exchanges, many taxpayers needed a way to utilize exchange funds to cover new construction (build-to-suit) or fix up (improvement) the replacement property. The inherent problem is that once a taxpayer takes ownership of the property, improvements to the property consist of payments to contractors for service and payment for material. Exchanges need to be “like-kind, ” i.e., real estate for real estate, not real estate for labor and materials. The 2001 regulations addressed this problem and provided that the taxpayer can retain the services of an Exchange Accommodation Titleholder (EAT) to take title to the property and cause the necessary construction/improvements be done to it.&nbsp; In a <a href="/blog/can-property-improvement-costs-be-part-1031-tax-deferred-exchange">build-to-suit or improvement exchange</a>, the EAT transfers the real estate to the taxpayer and the improved value, based upon the construction or improvements, is considered the receipt of the like-kind real estate<span style="text-decoration:none"><span style="text-underline:none">. </span></span><span style="text-decoration:none"><span style="text-underline:none">When improving the property in this manner, it does not matter if the EAT acquires the property and starts the work before the relinquished property is sold or after it is sold.&nbsp; </span></span></p>

<h2>Reverse Build-to-Suit/Improvement Exchanges</h2>

<p><span style="text-decoration:none"><span style="text-underline:none">If the construction or improvement process is begun prior to the sale, the same rules apply as above. However, the transaction is known as a reverse build-to-suit or improvement exchange. Whether a direct or reverse process is used, the maximum time the EAT can hold and improve the property is 180 days.</span></span></p>

<p>&nbsp;</p>

<p><em><span style="text-decoration:none"><span style="text-underline:none">Updated 6.24.2022.</span></span></em></p>