Real Property Probate and Trust Law Section  
  Real Property News  
  Reporter: John F. Wilcox
2215 E. Clairemont Ave, Eau Claire WI 54701: Tel.(715)832-6645, FAX (715) 832-8438, E-Mail

  Friday, 18 May 2007 Vol 4 Nr 7  

  In this issue  
The ABCs and 123s of 1031 Exchanges

By Patrick T Harrigan


Since 1031 exchanges are a real estate topic area with a number dominating its title, it seems appropriate to explore other numbers (and letters) associated with 1031 exchanges. This article explains some key 1031 exchange topic areas that are both new developments and important parts of the exchange process.


  The ABCs and 123s of 1031 exchanges  

Section 1031 is the section of the Internal Revenue Code that authorizes the procedure in which an individual or entity is able to defer payment of capital gains tax upon the sale of business or investment property. The seller, also known as the taxpayer, cannot sell the property outright. The sale must be structured as an exchange. Exchanges are completed by selling a relinquished property and acquiring a replacement property while adhering to strict rules created by Congress and the IRS. The vast majority of completed exchanges are forward exchanges where the taxpayer sells a property, uses an intermediary to facilitate the exchange and then purchases a replacement property at a later time. Reverse exchanges are possible and allow a taxpayer to effectively purchase the replacement property prior to selling the relinquished property.

15% and 25%

15% and 25% are the federal capital gains tax rates applicable to the majority of real estate sales. 15% is the standard federal tax rate on capital gains for property held more than one year for taxpayers above the 15% tax bracket. These same taxpayers will typically pay 25% on capital gains attributable to depreciations taken on the property.

Rates other than 15% and 25% may apply to a real estate sale. The capital gain rate is 5% for taxpayers in the 15% or under brackets and property held less than one year is typically taxed at the taxpayer’s ordinary income tax rate. Corporations that are Chapter C corporations typically pay at their ordinary corporate tax rate. Taxpayers should also be aware that they will need to pay state tax on capital gains and a real estate sale may cause Alternative Minimum Tax consequences. Of course each taxpayer’s tax liability can be unique dependent on that taxpayer’s circumstances. Completing a 1031 exchange allows the taxpayer to defer paying these capital gains taxes on a property sale.


Revenue Procedure 2000-37 created a safe harbor procedure for taxpayers to complete a reverse exchange. Prior to this procedure it was unclear (at best) whether or not a taxpayer could complete a valid 1031 exchange using a reverse procedure. Reverse exchanges arise from a timing problem where the taxpayer is scheduled to close on the property being purchased prior to the closing of the property being sold. In Rev. Proc. 2000-37, the IRS created a structure where the purchase of a replacement property can effectively occur prior to the sale of a relinquished property and a valid exchange is recognized.

Reverse exchanges are commonly referred to as “parked” exchanges. The reason for this terminology is because in reverse exchanges an Exchange Accommodation Titleholder (“EAT”) is used to take title to either the relinquished propert y (front leg reverse) or the replacement property (back leg reverse). The property is “parked” with the EAT as the titleholder of the property in order to complete the exchange as planned. In fact, from the taxpayer’s point of view the exchange is still a sale and then a purchase. However, by using the EAT to park one property the timing of the exchange becomes possible.

The largest issue with reverse exchanges is financing. The EAT is usually a special purpose entity created by the same company providing the intermediary services. In order to “purchase” or park one of the properties, the funds must be provided by the taxpayer. If the taxpayer does not have the cash to facilitate the “purchase” then any lender involved must understand and be able to work around the unique situation of a reverse 1031 exchange.


Section 121 of the Internal Revenue Code allows individuals selling their principal residence to avoid capital gains tax liability to the extent of $250,000 of gain for individuals and $500,000 for married couples. The taxpayer must have owned and used the property as their principal residence for 2 of the last 5 years. Section 121 and section 1031 can both be used in the sale of a single property where the character of the property is both the principal residence for the seller and used for business purposes. Typical examples include duplexes where one side is owner-occupied or farm property which includes a home and acreage. IRS Revenue Procedure 2005-14 provides guidance on applying section 121 and section 1031 to a single property sale.

HR 4520

On October 22, 2004, the American Jobs Creation Act of 2004 (HR 4520) was signed. It affected taxation on the sale of real estate by imposing a 5 year holding period on property acquired as replacement property in a 1031 exchange and later converted to the taxpayer’s principal residence. The upside of this legislation is that it approved by implication the ability of a taxpayer to convert property acquired in a 1031 exchange to principal residence property. The property must still be investment property (ie: rental) when acquired and the taxpayer cannot acquire the property with specific intent to later convert it to their principal residence. The downside is that the Act created a 5 year holding period between the time a taxpayer acquires the property in an exchange and the date the taxpayer is able to sell the property and use section 121 to avoid capital gains tax. The t axpayer must still fulfill all the requirements under section 121 to qualify for the principal residence exclusion.


Effective January 23, 2007, IRS Revenue Procedure 2007-12 set forth a new version of the certification form that a real estate closer must obtain in order to avoid 1099 reporting on the sale of a principal residence. According to Treasury Regulations, a real estate closing agent must provide a 1099 to both the IRS and the seller for real estate sale transactions by individuals unless the seller signs a certification stating that the principal residence exclusion applies. This Revenue Procedure adds 2 new statements to be certified by the seller in addition to the 4 statements that the certification form previously included. Those statements relate to the 5 year holding period rule noted in HR 4520 above and require that the seller certify that they (or a pass through basis donor) have not acquired the property in a 1031 exchange. If the seller has acquired the property in an exchange and 5 years has not passed then the principal residence exclusion does not apply.


45 is the number of days allowed by the Internal Revenue Code for a taxpayer to properly identify replacement property(ies) (or relinquished properties in a back leg reverse exchange). The 45 day period begins to run on the day of the closing of the relinquished property for a forward exchange. This time period is calculated using calendar days and is strictly enforced by the IRS. To properly identify a replacement property the taxpayer must provide a written, signed and unambiguous description of the replacement property within this time frame. There are 3 options for the number of replacement property(ies) that can be identified. Only one of the 3 options must be followed to have a valid identification. The 3 options are:

  • 3 properties - Up to any three properties regardless of their market values.
  • The 200% Rule - Any number of properties as long as the fair market value of the replacement properties do not exceed 200% of the fair market value of the exchanged property.

  • The 95% Rule - Any number of replacement properties if the fair market value of the properties actually purchased is at least 95% of the fair market value of all the replacement properties identified. In other words, the taxpayer must purchase no less than 95% of the value of all properties identified.

Except for the 95% rule, it is not necessary to purchase all identified properties, however, the taxpayer cannot purchase a property that was not identified within the 45 days and claim a valid exchange. The 45 day identification requirement is satisfied if replacement property is received (closed on) before 45 days has expired. The IRS does allow flexibility to revoke and change an identification within the 45 days.


180 days is the exchange period in which the taxpayer must complete the exchange in both forward and reverse exchanges. In a forward exchange this time period runs from the closing date of the property sold by the taxpayer and requires that the taxpayer close on the purchase of the replacement property within 180 days. This time period may be shortened if the due date for the taxpayer’s tax return falls within the 180 days. For example, if a taxpayer sells a relinquished property in December that taxpayer must complete the exchange before the due date of the taxpayer’s tax return on April 15th (March 15th for a corporate return) in order to properly report a completed exchange. If the full 180 days is needed a taxpayer can file for an extension. This time period is also a strictly enforced calendar day time frame.


QI stands for qualified intermediary. The IRS restricts the taxpayer’s ability to have actual or constructive receipt of the proceeds funds from the sale of the relinquished property during the exchange. The qualified intermediary is hired to hold those proceeds to avoid receipt by the taxpayer. The definition of qualified intermediary is set forth in the Treasury Regulations and was presumably created to ensure that the party playing this role is independent of and not subject to influence by the taxpayer. Qualifying to act as a 1031 exchange intermediary is not an objective standard as one might expect. It has nothing to do with competency or acquiring some sort of license or permit. Rather, it is determined for each exchange by the relationship between the taxpayer and the prospective intermediary. An intermediary may be qualified to act as an intermediary for one taxpayer and not for another. The Treasury Regulations provide that any person or entity can act as an intermediary un less they fall into one of 3 categories of persons or entities that are disqualified. Those 3 categories are:

  • The agent of the taxpayer. Examples include the taxpayer’s attorney, accountant, employee, real estate agent or broker. Routine financial and title insurance services as well as services with respect to properties intended to be part of an exchange are excluded;

  • Someone related to the taxpayer. Examples include the taxpayer’s spouse, parent, sibling or a business in which the taxpayer owns 11% or more and;

  • Someone related to the agent of the taxpayer. This third category is much lesser known and uses the other 2 categories to disqualify an intermediary. Examples include a title company partially or wholly owned by an attorney or real estate broker where that attorney or broker has provided services to the taxpayer.


Section 1.1031(k)-1(g)(6) (pages 106-107) of the Treasury Regulations is commonly referred to as the g(6) regulations. This section states the rules regarding when a taxpayer can receive exchange funds in the event that the taxpayer desires to cancel an open exchange. These regulations coincide with the taxpayer’s lack of ability to have receipt of the exchange funds during an exchange and they must be included in the exchange agreement between the taxpayer and the intermediary to have a valid exchange. The return of funds follow these rules:
  • If no properties are identified then funds can be returned on day 46 which is the earliest time that funds can be released;
  • If properties are properly identified within the 45 day identification period, remaining funds can be returned when:

    • All identified properties are purchased;
    • The 180 day exchange period has expired;
    • A substantial and material contingency beyond the taxpayers control exists (very gray area).

These regulations can also come into play on the closing of the replacement property being purchased by the taxpayer. If a taxpayer receives funds at the closing on the replacement property, which often occurs when the taxpayer takes out a mortgage loan in excess of the total funds needed to complete the purchase, the IRS may view this as a g(6) violation if the regulations concerning the release of funds are not followed.


LLC stands for Limited Liability Company which is a type of business entity. LLCs are a creation of state law but have federal tax law implications. The significance for 1031 exchanges comes in the form of the “same taxpayer” rule. This rule states that the same taxpaying person or entity must sell the relinquished property and purchase the replacement property in order for a valid exchange to have taken place. One exception to this rule is that an individual who is in title to the relinquished property can acquire the replacement property in a single member disregarded LLC. The IRS considers this LLC the “same taxpayer” as the individual. Also, under Rev. Proc. 2002-69, if a husband and wife are the only members of an LLC in a community property state (such as Wisconsin) that LLC can still be considered a “single member” disregarded LLC for tax purposes.

A taxpayer must also be wary of how title to the replacement property is held. For instance, if a taxpayer were to purchase replacement property with another individual using the name of a partnership as the titleholder, a violation of the “same taxpayer” rule has likely occurred. This taxpayer has purchased a partnership interest and not real estate as required by the exchange regulations. Another example may occur when a taxpayer, who was the sole owner of the relinquished property, places a spouse on the title to the replacement property. The IRS may view this transaction as a purchase by the taxpayer of only ½ of the replacement property and a gift to the spouse of the other ½ of the exchange funds. Depending on the market values of the properties involved this could create tax consequences.


8824 is the IRS form to be filed with a taxpayer’s 1040 form to report a 1031 exchange.


FMV stands for fair market value. In order for a taxpayer to enjoy the maximum capital gains tax deferral, the replacement property must be equal or greater in fair market value to the relinquished property. The taxpayer must also be careful to send all the net proceeds funds from the relinquished property sale through the exchange and reinvest those funds in the replacement property.


The first sentence in Section 1031 of the Internal Revenue Code states that property must be exchanged for property of “like kind.” This language produces some of the largest myths in exchanging when taxpayers believe that they must exchange property for another of similar use.

Actually, all real estate is considered like kind to real estate so long as it is held for productive use in a trade or business or for investment purposes. For example, improved real property can be exchanged for unimproved real property, a duplex can be exchanged for a four-plex, rental property can be exchanged for retail property, office property can be exchanged for a warehouse, etc.

Personal property exchanges are more restrictive when determining like kind and a taxpayer should consult with their tax professional regarding exchanges of personal property.


TIC stands for tenant-in-common which is a form of common ownership of real estate that has existed for centuries. It is now a term for a growing industry that sprung up beginning primarily in 2002 with a Revenue Procedure that allowed certain property investment structures to be classified as real estate, thus, allowing 1031 exchange taxpayers to buy into these replacement properties.

The TIC industry markets large institutional grade properties, such as office buildings, to 1031 exchange taxpayers who desire a passive investment with a cash flow return on that investment. The taxpayer becomes one of possibly dozens of individuals who own a fraction of that property as common owners.

These investments are primarily offered through securities broker/dealers who “sell” the taxpayer the fractional ownership interest in a property being offered by a sponsor who arranges the transaction.

Contact information:

Patrick Harrigan

Patrick T. Harrigan has over 10 years of experience with real estate transactions and has focused his efforts exclusively on 1031 exchanges for over 3 years. Patrick received his Juris Doctorate degree from Hamline University School of Law and his Bachelor of Science degree in Political Science from the University of Wisconsin-Green Bay. He is a member of the State Bar of Wisconsin and the Minnesota State Bar Association. He is a frequent speaker on the process of completing 1031 exchanges and member of the Federation of Exchange Accommodators.



For assistance with 1031 exchange services see Gain 1031 Exchange Company in Milwaukee, Wisconsin and Minneapolis, Minnesota.



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