Any Hawaiian 1031 Exchange must involve property that will be used in a business, investment, or trade and be like other properties. This will allow the Exchanger to defer any gains or losses that are due upon the sale of the relinquished property for the replacement property. The likeness is meant to be understood as something similar in nature and character. This is only implied in the grade or quality of the property and not its kind or class.
An example of this type of trade is vacant land being held for investment. It may be exchanged for single-family rentals used for a trade or business or any combination of the following: single-family rentals, ranches and farms, golf courses, commercial and office buildings, hotels and motels, multi-family rentals, vacant land, industrial, retail and leasehold properties of 30 years or more.
The delayed exchange is the most commonly utilized tax planning strategy for investors. This happens when there is a delay between the sale of relinquished property and the purchase of the replacement property. Since the 1979 federal case where the validity of the delayed exchange was changed, there is now a 45-day identification period and a 180-day exchange period. This means investors have up to 180 days to purchase a replacement property once their relinquished property has closed escrow.
The Delayed Exchange occurs in three steps. First, the Exchanger must retain a Qualified Intermediary to prepare an exchange agreement, assignment of sale contact, and closing instructions to the escrow closing agent before closing on the sale of the relinquished property. The QI is responsible for instructing the escrow agent to direct deed the relinquished deed to the buyer and to deliver sale proceeds to the exchange company. The Exchanger will not have actual receipt of the funds and once the funds are delivered to the exchange entity, they will be restricted for the remainder of the exchange period.
Next, the Exchanger must identify the replacement property within 45 days of the relinquished real property close of escrow. The Exchanger must designate the replacement property in written document to the seller of the replacement property to give a valid identity to the exchange property.
Three different identification rules will apply. One, the 3-property rule wherein three properties must be identified no matter what the fair market value. Next is the 200 percent rule where any number of properties as long as the aggregate fair market value does not exceed 200 percent of the fair market value of all the relinquished properties. The third rule is the 95 percent rule. This is where any number of properties without any regard to value, providing 95 percent of the value of the identified properties, is acquired.
Last, within 180 calendar days from the date of sale of the relinquished property, the Exchanger must acquire a replacement property. The property that is acquired must be one or all of the previously identified replacement properties. The Exchanger will once again assign the purchase and sale contract to the exchange company. The exchange company will then purchase the replacement property with the exchange and proceeds and causes the transfer of the replacement property to the Exchanger by way of a direct deed from the seller.
A Reverse Exchange happens a little differently than a Delayed Exchange. The Exchanger will acquire a replacement property before the sale of the relinquished property. This will then prompt them to have the QI purchase the replacement property and hold the title while the Exchanger is sells the relinquished property. The Reverse Exchange must also be completed within 180 days.
There are two types of Reverse Exchanges. One is the Exchange Last version. This is when the title to the replacement property is held by the exchange accommodation titleholder (EAT). The Exchanger will enter into a written agreement with the EAT, who will hold the title for the replacement property until the relinquished property is ready to close escrow. The EAT will then then transfer the title to the Exchanger in exchange for causing the transfer of the relinquished property to a third party buyer.
The other type is called Exchange First. This type requires the QI to purchase the replacement property and causes it to be deeded directly from the seller to the Exchanger in exchange for the Exchanger’s transfer of the relinquished property to the exchange accommodator. The exchange accommodator will hold the relinquished property until a buyer is found, and that person will then sell the relinquished property.
The Exchanger and the exchange accommodator will enter into a written agreement. The Exchanger must identify one or more relinquished properties within 45 days. This must be completed within 180 days.
A major issue arises when the Exchanger is selling his relinquished property and he uses Exchange Proceeds to pay off either expenses incurred for the exchange or settlement fees paid through escrow. When an expense is paid by using sales proceeds it reduces the amount that is sent to the Exchange account. If the expense is allowed to be paid with the proceeds it does not cause a problem, but if the expense is not allowed, it causes a taxable event which will subject those expenses to capital gain treatment.
If the allowed expenses are paid with exchange funds, the IRS deems the Exchanger as having constructive receipt of those funds, thus the Exchanger has received the case and then paid for the expenses himself, which will subject the Exchanger to boot in the transaction, creating a taxable event.
Some exchange expenses allowed to be paid for with exchange funds include: sales commissions, finders’ fees, legal fees, escrow fees, accommodator fees, transfer fees, document preparation fees, messenger fees, notary fees, processing fees, and loan payoff. Some examples of non-exchange expenses include: homeowners’ dues, rent proration’s, property taxes, property liability insurance, utilities, repairs, termite treatment, and replacement property loan acquisition fees.