Internal Revenue Code § 1031: Tax-Deferred Exchanges What is a “1031 exchange?” IRS Code § 1031 allows real property to be exchanged for other real property without the immediate payment of capital gains tax. In a 1031 exchange, the seller of appreciated property may “exchange” appreciated property for other real property “of like kind” to avoid paying taxes on the gain. Taxes on the increased value of the transferred (“downleg”) property will be deferred up to the value of the received (“upleg”) property. What if the upleg property is purchased for less than sales price of the downleg property? If the upleg property is purchased for less than the sales price of the downleg property, the difference in values will be immediately taxable as “boot.” What types of property are eligible for a 1031 exchange? Section 1031 applies to the exchange of real property for any other real property. However, it does not apply to properties held for personal use. Nor does it apply to properties that are intended to be sold. Rather, both the upleg and the downleg properties in a 1031 exchange must be held for use in a trade or business, as an investment, or for production of income. If either property is used as a personal residence of the exchangor, an exchange will not be eligible for tax deferral. After an exchange is completed, how long is it necessary to wait to convert the property to personal use? First off, if that was the intention all along, then the property might not qualify as a 1031 exchange. However, after an exchange is completed, an exchangor may eventually convert the upleg property to personal use. It is not clear how long the upleg property must be used for business, trade, or investment purposes before conversion in order to avoid problems with tax authorities, but most tax professionals recommend a period of at least two years. Do the purchase and sale of properties involved in a 1031 exchange have to be simultaneous? No. A taxpayer may acquire an upleg property after disposing of a downleg property so long as: • An upleg property is identified within 45 days of the sale of the downleg property and; • The purchase of the upleg property closes no later than 180 calendar days after the downleg property is transferred, OR the due date (determined with regard to extension) of the tax return for the year in which the downleg was transferred away. A taxpayer may also receive tax deferral through a “reverse exchange” in which the upleg property is purchased prior to the sale of the downleg property. How should a Section 1031 exchange be structured? There are numerous ways to structure an exchange, and the best method will depend on the specific circumstances at hand. An exchange should be facilitated by a person or entity with expertise in the area, known as an “exchange accommodator” or “qualified intermediary.” The exchange accommodator must be an “unrelated party” with no existing relationship to the exchangor. Copyright©, 2018 California Association of REALTORS®. June 21, 2018 (revised).

IRC §1031 allows you to defer capital gain tax when you sell real property used for business or investment purposes, and purchase like-kind property. A 1031 Exchange will also defer depreciation recapture provided the replacement property is also improved real property. The §1031 regulations require you to use a Qualified Intermediary (“QI”), also known as accommodator or facilitator, in 1031 Exchanges. The QI must be assigned into the contract on the property you are selling before escrow closes. Once escrow closes, the QI will hold the proceeds from the sale of the property. These proceeds are restricted for certain periods. You may withdraw proceeds before funds are sent to the QI, but withdrawals will be taxable boot. From the date escrow closes, there are two statutory timelines. You have 45 calendar days to identify property you are going to purchase and 180 calendar days to close on your replacement property. There are no extensions for weekends or holidays. If the 45th or 180th day falls on a Sunday, that is your deadline. When identifying property, you can use either the 3 Property Rule (identify up to 3 properties regardless of their value) or the 200% Rule (identify as many properties as you want up to an aggregate fair market value of 2 times what you sold). Under §1031 all real estate is considered to be like-kind with all other real estate, as long as both the properties sold and purchased are used for investment or business purposes. So, a primary residence or second home cannot be used in a 1031 Exchange. Property purchased for resale, such as “flipped” homes, also don’t normally qualify for 1031 Exchange. Single-family rental homes, condos, commercial property, farm land, bare land and any other interest in real estate that is held for business or investment, and is located in the United States, is like-kind and can be exchanged. You can also buy and sell multiple properties within one exchange. In order to defer all capital gain, your net purchase price must be greater than your net sales price. As an example, a property sold for $800,000 may have a net sales price of $750,000 after commissions and other qualified closing costs. A purchase of at least $750,000 is required to defer all capital gain tax. If you buy a property of lower value than you sold, you will be liable for taxes on the difference (this is known as “boot”). In addition, all the equity (proceeds) must be used towards the Replacement Property(ies). Any proceeds left over after the exchange is completed are also boot. You need to be sure that your money is secure since all Qualified Intermediaries are not created equal. Here are some important questions to ask any QI before you hand them your money: • How long have they been in business? • Are they bonded, and what is the size of the bond? • Do they have errors and omissions insurance coverage? • Do they have a written guarantee your money will be there when you need it to purchase replacement property?

Qualified Intemediary -Is a Qualified Intermediary (AKA accommodator or QI) needed? Yes. The IRS requires the use of an intermediary in virtually every 1031 transaction and the QI must be engaged before the relinquished property is sold. Like Kind -Can I sell my rental house and buy a 4plex? Can I sell my va- cant lot and buy a rental house? Yes, you can buy ANY kind of business or investment real estate, anywhere in the US. You can sell the rental house and buy apartments, commercial, industrial, mini storage, bare land, agricultural, etc. Timing -Can I buy the replacement property first? Yes, but that is called a “reverse exchange”, which is more expensive and more work. Time Deadlines -Do I have to be in contract by the 45 days? The identification form only requires that you give us the addresses to the properties you are identifying by the 45th day. However if they are sold to someone else on Day 46, you are out of luck. So it is recom- mended that you are in a firm contract by then. -Do I have to buy from the properties I’ve identified? Yes. During the 45 days you can change what you’ve identified, but once your identification period is up, you must buy from only that list. No substitutions or changes after day 45. -Can I get an extension on the 45 day identification period? No. Unless you have been affected by a federally declared disaster, the IRS doesn’t have any provisions for extensions or exceptions – not even to the next business day if the deadline falls on a weekend or holiday. The best way to get more time is to start looking for your replacement property well before the closing of your sale property or to extend the closing date on your sale property. Improvements -Can I get money back for making improvements to the property before I sold it? What you did with the property is a separate issue from the exchange itself. If you receive some cash back at the close of escrow to “pay your- self back” that is taxable boot. However, your tax advisor may be able to create some tax deductions to offset your taxable boot. -Can I use money from the exchange to improve the new prop- erty after I buy it? The day you take title to the property is the end of the exchange for that property. If you have cash left over, that is taxable boot. There is something called a build-to-suit or improvement exchange, where we, as the intermediary, take title to the property to make the improve- ments before you take ownership. This is also a more expensive and complicated transaction. Money -Do I just need to reinvest my profit? No. To defer all your taxes, you need to replace the entire net sales price of what you sell, not just the gain. [“Net” refers to the sales price less the closing costs, such as escrow, title, and broker fees. Do NOT subtract the loan balance.] -Do I have to replace my existing loan amount? Yes, you are not just reinvesting the equity, you need to buy equal or greater to the entire net sales price. -Do I have to get another loan? You need to replace the VALUE of the loan. Either with another loan or with additional cash you may have. Moving In -Can I move into the property I buy? The replacement property needs to be purchased with the intent of being a business or investment property. In 2008 the IRS issued a safe- harbor (Rev. Proc. 2008-16) that defines how to treat your replacement property for the two-year period after the exchange in order to safe- harbor your exchange. A common belief is that you can then convert it to personal use. However, any type of conversion needs to be discussed with your tax advisor first. Family -Can I rent the property to my child or other family member? Yes, but they need to be treated like a regular tenant, including paying fair market rent for the property. -Can I buy the property with someone else? Yes, but you would need to buy the property as tenants-in-common, where your share of the property should be equal or greater to what you sold. Also, do not create a partnership or multiple-member LLC to own the property. How you structure the co-ownership of property coming out of an exchange should be discussed with your tax advisor. Vesting and Title -Do I need to buy the replacement property in the exact same vesting as I sold? No. It needs to be the same TAXPAYER. So you can sell the property in your revocable trust and buy it in your name because you are the same taxpayer. However you cannot sell as a partnership and buy as individuals – those are not the same taxpaying entities.