The Exchange Update
A Newsletter For 1031 Tax-Deferred Exchanges
Acquiring 1031 Exchange Property through Short Sales, Auctions and Foreclosures
Distressed sales continue to account for a significant portion of the sales volume in many markets. Investors with access to cash are acquiring properties in short sales, auctions and foreclosures, and in some cases they are selling properties in a 1031 exchange and using their exchange funds to acquire these distressed properties.
Investors who sell property in an exchange and use the funds to acquire property that is being sold by a lender in a short sale, auction or foreclosure need to keep in mind the 1031 exchange rules that may complicate the process.
In a short sale, the bid package must be approved by the lender that owns the property, and in some cases this approval may take longer than expected. Lenders appear to be approving packages more quickly, but an investor needs to pay attention to the timing. In a 1031 exchange, the investor must identify replacement property within 45 days and close within 180 days after the close of the property being sold (relinquished property).
In order for a sale followed by a purchase to be considered an exchange for tax purposes, the investor cannot have control of the funds from the sale. The qualified intermediary must hold the funds and the regulations say that the funds should only be delivered to the seller of the replacement property after the investor assigns to the intermediary his rights under the purchase contract. If the funds are sent (as a deposit or as the purchase price) to the seller before the investor assigns his rights under a signed purchase agreement to the intermediary, there is a possibility that the 1031 exchange could be disqualified.
Because of this rule, it can be difficult to acquire foreclosure or auction property in an exchange. In a foreclosure, there is no contract to assign. In an auction, there may not be a contract, but even when there is a contract, the seller often requires the successful bidder to make a deposit before the contract is signed. In that case, investors will sometimes use their own funds to make the deposit rather than risk causing their exchange to be disqualified.
In a short sale, some lenders will also require a deposit before the lender will sign the purchase agreement. In order to avoid the constructive receipt issue, many investors will use their own funds to make the deposit and get reimbursed later from their exchange funds.
In a 1031 exchange, the investor must assign its rights to the qualified intermediary under the purchase and sale agreement, and all of the parties to the transaction must be notified of this assignment. Typically, in a replacement property closing, the seller signs a document acknowledging notice of this assignment; however, in some cases a lender selling property in a short sale may refuse to sign this acknowledgement. One solution that some investors use is to ask the escrow agent or closing agent to state in writing that they sent the notice of assignment to the lender. This gives the investor evidence that they have complied with this requirement in case they are audited.
Another typical practice in an exchange is to show the qualified intermediary as the seller or buyer on the settlement statement. Sometimes lenders who are selling property in a short sale won’t allow escrow to list the intermediary on the statement. Although this is not ideal for the investor, most tax advisors feel that it should not adversely affect the exchange as long as the exchange documents are signed before the closing of the relinquished property and the investor does not touch any of the exchange funds.
It also may be difficult to do a reverse exchange when the qualified intermediary is taking title to property that is being sold in a short sale because the lender may not allow the intermediary to go on title. This possibility should be explored before planning a reverse exchange with property being sold in a short sale.
All of these details should be thoroughly investigated and resolved before attempting to combine a 1031 exchange with a short sale, foreclosure or auction. If you have any questions about these types of exchanges, please contact us at First American Exchange and we would be happy to assist you.
Top Ten Identification Rules for 1031 Exchanges
For a successful 1031 exchange, it is important to understand and comply with the 1031 exchange identification rules. These rules are not that complicated, but a failure to follow the rules may ruin your exchange. Here are the top ten things to remember when identifying replacement property in an exchange:
1. Deadline and General Rules. The taxpayer has 45 days from the date that the relinquished property closes to identify the replacement property that he intends to acquire in the exchange. If there is more than one relinquished property in one exchange, the 45 days are measured from the date the first relinquished property closes. The property identified does not have to be under contract, and the taxpayer does not have to acquire everything that he identifies. It is important to note, however, that the taxpayer is not allowed to acquire anything other than the property that he has identified, and a failure to comply with the identification rules can ruin the whole exchange.
2. 3 Property Rule. There are rules that limit how many properties the taxpayer may identify. In most cases taxpayers use the three property rule. The taxpayer may identify up to three replacement properties and may acquire one, two or all three of those.
3. 200% Rule. If the taxpayer wants to identify more than three properties, he can use the 200% rule. This rule says that the taxpayer can identify any number of replacement properties, as long as the total fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property. First American Exchange recommends that taxpayers build in a “cushion” by identifying properties that are worth less than what is permitted, in case some properties are later determined to have a higher value than what was originally estimated.
4. 95% Rule. There is another rule that is not commonly used by investors. The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies. Essentially, the taxpayer will need to acquire everything that he has identified to make this work, and that is why it is not relied on too often.
5. Property Acquired in 45 Day Period. Any property that is actually acquired during the 45 day identification period is deemed to be properly identified. It’s important to note that if some property is acquired during this period and some property is acquired later using another one of the identification rules, the property acquired during the first 45 days needs to be counted as one identified property. For example, if you acquire one property during the first 45 days and you plan to use the 3 property rule and buy more properties after the 45 days, you only have two more properties to identify because you have already used up one.
6. Manner of Identification. The identification must be in writing and signed by the taxpayer, and the property must be unambiguously described. This generally means that the taxpayer identifies either the address of the property or its legal description. A condo should have a unit number, and if the taxpayer is buying less than a 100% interest, the percentage share of what is being acquired should be noted.
7. Who Must Receive the Identification. The taxpayer must send the identification notice either to:
1) The person obligated to transfer the replacement property to the taxpayer (such as the seller of the replacement property) or;
2) To any other person “involved” in the exchange (such as the qualified intermediary, escrow agent or title company), other than a “disqualified person,” such as an agent or family member of the taxpayer. Most identification notices are sent to the qualified intermediary.
8. Replacement Property Must be Same as What Was Identified. The taxpayer must receive “substantially the same” property as he identified. The regulations contain four examples to illustrate what “substantially the same” means. In one example, the taxpayer identifies two acres of unimproved land and then acquires 1.5 acres of that land. The property acquired is substantially the same because what the taxpayer received was not different in nature or character from what was identified, and the taxpayer acquired 75% of the fair market value of the property identified. In another example, the taxpayer identifies a barn and two acres of land, and then acquires the barn with the land underlying the barn only. The IRS says that the property acquired was not substantially the same as the property identified because it differed in its basic nature or character.
9. Property to be Constructed. If the replacement property is under construction at the time of identification, the taxpayer must include not only the address or legal description of the property, but also must include a description of what is to be constructed on the property.
10. Reverse Exchanges. If the taxpayer is doing a reverse exchange where the accommodator acquires the replacement property before the taxpayer closes on the sale of the relinquished property, the taxpayer must identify in writing what he intends to sell and that identification must be sent no later than 45 days after the accommodator closes on the replacement property.
If you have any questions about the identification rules, please contact us at First American Exchange and we would be happy to assist you.