Deferred IRC 1031 Exchange in Hawaii
To qualify for an IRC 1031 Deferred Tax Exchange for Maui real estate, the exchange properties must be held for productive use in a business, investment or trade and be like-kind. This will enable the Exchanger to defer the recognition of capital gains or losses that are due upon sale of real property onto a newly acquired property.
Qualified Properties in Hawaii
The IRC 1031 Exchange provides that in order for an individual to qualify for a tax deferred treatment, the property to be relinquished must be exchanged for a replacement property that is of like kind. Like kind is interpreted as similar in nature and character. The fact that any real estate involved is improved, or unimproved, is not material for that fact relates only to the grade or quality of the property and not its kind or class.
For instance, vacant land being held for investment may be exchanged for single-family rentals used for a trade or business or any combination of the following: single-family rentals, ranches, farms, golf courses, commerical, office, hotels, 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 available to investors. A Delayed Exchange occurs when there is a time delay between the sale of the relinquished property and the purchase of the replacement property. Also known as the "Starker Exchange", due to landmark 1979 federal case wherein the court substantiated the validity of the delayed exchange process. Prior to the Starker case, the 1031 of the Internal Revenue Code authorized tax-free exchanges of personal and real property. Thereafter, Congress created the 45 day identification period and the 180 day exchange period.
This exchange provides Hawaii real estate investors up to 180 days to purchase a replacement property once their relinquished property has closed escrow. In order for this to be a valid exchange, a QI is required to facilitate the process. The Delayed Exchange occurs in three steps:
- Before closing on the sale of the relinquished property the Exchanger retains a Qualified Intermediary whom prepares an exchange agreement, assignment of sale contact and closing instructions to the escrow closing agent. The QI instructs the escrow agent to direct deed the relinquished property to the buyer and to deliver sale proceeds directly to the exchange company. This will prevent the Exchanger from having actual receipt of the funds. Once the funds are delivered to the exchange entity, access to the funds is restricted for the remainder of the exchange period.
- The Exchanger must identify the replacement property within 45 days of the close of escrow on the relinquished real property. The identification of the exchange property is valid only if the replacement property is designated as replacement property in a written document signed by the Exchanger and mailed, hand delivered, or telecopied to the seller of the replacement property or to any other person involved in the exchange other than the Exchanger or a disqualified person. Either one of these three identification rules will apply:
- The 3 property rule wherein three properties must be indentified no matter what the fair market value.
- The 200% rule where any number of properties as long as the aggregate fair market value does not exceed 200% (2x) of the fair market value of all the relinquished properties.
- The 95% rule where any number of properties without any regard to value, providing 95% of the value of the identified properties are acquired.
- Within 180 calendar days from the sale of the relinquished property, the Exchanger must acquire a replacement property and the property acquired must be one or all of the previously "identified" replacement properties. The Exchanger again assigns the purchase and sale contract to the exchange company, who purchases the replacement property with the exchange proceeds and causes the transfer of the replacement property to the Exchanger by way of a direct deed from the seller.
A Reverse Exchange occurs when the acquired replacement property occurs prior to the sale of the relinquished property. The Exchanger utilizes the Qualified Intermediary "QI" to purchase the replacement property and hold title while the Exchanger markets the relinquished property. The Reverse Exchange must be completed within 180 days, as done with the Delayed Exchange. There are two types of Reverse Exchanges:
- The Exchange Last version occurs where the title to the replacement property is parked with the exchange accommodation titleholder. The Exchanger then enters into a written agreement with the EAT who then acquires title to the replacement property and holds it until a buyer is found for the relinquished property. Once this property is ready to close escrow, the titleholder then enters into a simultaneous exchange with the Exchanger, thus transferring title to the replacement property to the Exchanger in exchange for causing the transfer of the relinquished property to a third party buyer.
- The Exchange First is where the QI acquires the right 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 relinquished property is held until a buyer is discovered. Once the occurs, the relinquished property is then sold to the third party buyer by the exchange accommodator.
The time allotted is no later than five business days after the exchange accommodator acquires its ownership interest in the parked property, the EA and the Exchanger must enter into a written agreement. The Exchanger must identify one or more relinquished properties with 45 days. Written identification of the relinquished properties must be delivered to the EA or to another party to the Reverse Exchange and must be completed within 180 days.
Approved Settlement Fees
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 for, the Exchanger 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 for with exchange funds, the IRS deems the Exchanger as having constructive receipt of those funds, thus the Exchanger has received the cash and then paid for the expenses himself, which will subject the Exchanger to boot in the transaction and creating a taxable event.
Here is a list of exchange expenses allowed to be paid for with exchange funds: sales commissions, finders fees, legal fees, escrow fees, accommodator fees, transfer taxes, document preparation fees, messenger fees, notary fees, processing fees and loan payoff.
The following is a list of non-exchange expenses which should be paid for with outside funds or it may be considered boot and create a taxable event: homeowners dues, rent prorations, property taxes, property liability insurance, utilities, repairs, termite treatment and replacement property loan acquisition fees.
OREXCO 1031 Exchange
When you choose OREXCO, Old Republic Exchange Facilitator Company, for your 1031 Tax Deferred Exchange of Hawaii real estate, who will be working with the wholly-owned subsidiary of Old Republic International Corporation. One of the nation's largest insurance companies, Old Republic National Title Insurance assures the security of your exchange proceeds in the state of Hawaii.
If you are considering a 1031 Deferred Tax Exchange on any of the Hawaiian islands, please contact their Vice President and Hawaii Regional Manager, Julie Tumbaga. She is a Certified Exchange Specialist, contact her at (877) 591-1031, email at JTumbaga@orexco1031.com or www.orexco1031.com. Trust Brad Hill with your next Maui real estate transaction if it involves a 1031 Exchange as he has worked with OREXCO and have closed many exchange transactions between the mainland and Hawaii.