Legal 1031 Exchange Dictionary

Section 1031 of the Internal Revenue Code (“§1031 of the IRC”) can be a complex part of the tax code, and the ins-and-outs of transacting exchanges can even be a tough topic for the most sophisticated investors. We have compiled a list of common 1031 exchange and commercial real estate terminology as a resource for our clients and our network of professionals. Please contact us if you have any questions or if you would like to discuss an exchange.

1031 EXCHANGE:
A tax deferred exchange of real property for like-kind real property, pursuant to Section 1031 of the Internal Revenue Code. All real property involved in the exchange must be held for business use or for investment. Read our article to learn more.

(g)(6) RESTRICTIONS:
Refer to Treasury Regulation 1.1031 (k)-1(g)(6) and limit the Seller’s rights to receive exchange funds held by the qualified intermediary prior to the end of the exchange period, or to pledge or otherwise obtain the benefits of during the exchange. See also Constructive Receipt and Qualified Escrow Restrictions below.

ACCREDITED INVESTOR:
According to the Securities and Exchange Commission, an “accredited investor” is an individual investor who either (1) earns an income of over $200,000.00 yearly; (2) jointly earns an income of over $300,000.00 yearly; or (3) is an investor who has a net worth of over $1,000,000.00, not inclusive of the fair market value of their primary residence. The full requirements for individuals and various entities are explained in 17 CFR § 230.501(a). In the context of 1031 exchanges, this is relevant when an investor is considering replacement property marketed by a sponsor. For example TIC or DST structures that involve several co-owners and is considered a private equity placement.  To read more about DSTs, check out our article linked here.

ACTUAL RECEIPT:
Refers to the physical possession of exchange proceeds by an exchanger or taxpayer. Read more about actual receipt, check out our article here.

ADJUSTED BASIS:
A property is calculated by taking the cost basis of the property, plus the costs of capital improvements, minus depreciation taken during the length of ownership. Calculating the adjusted basis of a property is a key component in analyzing a potential 1031 exchange. Obtaining your adjusted basis from your CPA will help you properly determine the amount of gain or loss upon the sale or disposition of a property. See also Cost Basis below.

AIR RIGHTS:
Are an intangible interest in real estate which refers to the right to use/occupy the vertical air space over a piece/plot of real estate. These air rights can qualify as real property under §1031 of the IRC and can be exchanged for “like-kind” real property.

BASIS, aka COST BASIS:
An asset is its cost to the taxpayer. The basis can be calculated by adding the amount paid in cash for the asset, plus any debt obligations, plus other services and eligible costs related to the acquisition of the property.

If buying stocks and bonds, your basis is essentially the purchase price, plus any brokerage fees/commissions and transactional fees.

Similar to stocks, for real property, your cost basis is essentially the purchase price, plus any brokerage fees/commissions, advisory fees like attorneys and CPAs, title fees, and closing costs and transactional fees and taxes. To learn more about allowable expenses, check out our article here.

If the property was a gift or inheritance, wherein there is no cash exchanged, the basis is deemed to be the fair market value of the property on the date of the transfer.

BOOT:
A term used to refer to any portion of the sales proceeds received in a 1031 exchange that is not reinvested in eligible “like-kind” replacement real estate or used to pay for an eligible cost of acquiring the replacement property. Boot is generally subject to capital gains tax, but in some cases can be taxed as ordinary income. Several factors may create boot, including cash proceeds, mortgage reduction, non-transactional costs, non-like-kind property, and personal property.

For example, if a commercial property is sold for $500k, but only $400k is reinvested into the replacement commercial property, the $100k difference is boot. Thus, in this example, the full $100k would be subject to capital gains tax.

BUILD-TO-SUIT EXCHANGE:
A term of art for an improvement exchange or construction exchange (See Improvement Exchange below), wherein the exchange is structured so that either an accommodator, seller, or a landlord customizes/improves a property pursuant to a buyer or a tenant’s specifications, thereby building the property “to suit” the buyer or incoming tenant.

CAPITAL IMPROVEMENT:
An improvement which materially adds to the property’s value and prolongs the property’s useful life. When an investor makes a capital improvement to their property the amount of the improvement is added to their basis and becomes part of the calculation of their adjusted basis. If improvements made to a property do not add value and prolong its life, then they are considered a repair and not a capital improvement (See Repairs below). General repairs and maintenance are not considered capital improvements. Replacing the roof of a building is normally considered a capital improvement; however, fixing a roof leak is considered a repair.

Section 263(a) of the IRC requires a taxpayer to capitalize the costs of acquiring, producing, and improving tangible property, regardless of the size or the cost incurred. 

CAPITALIZATION RATES, aka CAP RATES:
Popular measures used to assess commercial real estate properties for their profitability and potential for return. The cap rate is calculated by dividing the property’s net operating income, by its purchase price.

COMMERCIAL REAL ESTATE:
A property used for business and investment purposes, rather than as a personal residence. It has the potential to generate profit and investment; commonly done through collecting rental income.

Some examples of 1031-eligible commercial properties are apartment buildings, office buildings, retail buildings such as shopping centers/malls, medical centers, hotels/motels, convenience stores and gas stations.

CONSERVATION EASEMENTS:
Legal agreements that protect the natural resources of a property by limiting its land use and development. Additionally, the Conservation Easement Tax Credit (CETC) affords the landowner a “refundable income tax credit on their school district, county, and town property taxes paid during the year.” The easement is recorded with the property’s deed and thus transfers to all future landowners.

CONSTRUTIVE RECEIPT:
A complex income tax concept whereby a taxpayer can be deemed “in receipt of income” even though cash or other property was not actually transferred to the taxpayer. In general, a taxpayer has received income when they have control over money or property (directly or indirectly through an agent) or where they have an unrestricted right to obtain it. Constructive receipt is the reason that an exchange agreement with a qualified intermediary is necessary to set up a deferred 1031 exchange. Unless there are substantial limitations or restrictions on a Seller’s control over sales proceeds at the moment of sale, they may be considered available to the Seller even though they did not receive cash yet. An exchange agreement with an intermediary should always provide that it restricts the Seller’s rights to the real estate sale proceeds under the “(g)(6) restrictions” discussed above. To read more about actual and constructive receipt, check out our article here.

COST SEGREGATION: ??

DEALERS/WHOLESALESERS/FLIPPERS:
IRS terms for taxpayers (individuals or business entities) that hold property for re-sale and do not acquire it with investment intent. Generally, property held for re-sale and for reasons other than investment, does not qualify for a 1031 exchange. Likewise, such property may not meet the criteria for a capital asset and is considered inventory. Developers who build and hold property only for re-sale and are considered “dealers” by the IRS. If these dealers/developers adjust their business model to hold the newly constructed real estate long-term and stabilize it as a rental asset, they may qualify for 1031 exchange tax deferral. Check out our website articles to read more about flippers, dealers and investment intent, and to learn about when investment intent is measured.

DEBT BOOT, aka MORTGAGE BOOT:
Occurs when a taxpayer’s debt/mortgage on replacement property is less than the debt/mortgage that was on the relinquished property at the time of sale. To qualify, the mortgage on the replacement property must equal or exceed the mortgage on the replacement property; any difference will be subject to capital gains tax.

DELAWARE STATUTORY TRUST (DST):
A legal entity formed under Delaware law, allowing for fractional ownership interests in investment real estate. It functions similarly to a partnership or other pass-through entity, providing limited liability and pass-through income and tax benefits to its members. Legally recognized as separate from its owners, a DST does not report income at the trust level for tax purposes. This structure is particularly appealing to 1031 exchange investors because it qualifies as “real property” under Section 1031, enabling the buying, selling, or exchanging of individual beneficial interests while deferring capital gains. This level of separation in tax identity is not found in multi-member LLCs or S-Corporations, making DSTs a unique and complex option for co-investment and tax deferral. To read more about DST interests, read our article here.

DEPRECIATION:
Sometimes referred to as “cost recovery”, is the periodic expending of an asset over the property’s theoretical economic life. See IRC §1250 for capital assets and IRC §1245 for personal property/equipment/business property. Depreciation is intended to recognize the decrease in value caused by, among other things, wear and tear, and outdated interior improvements. Land is generally not depreciable, and an investor must allocate the purchase price (“cost basis”) between the land and improvements.  See also Cost Segregation.

DIRECT DEEDING: 
The process by which a seller/property owner transfers ownership of their property directly to the buyer, instead of transferring title to a qualified intermediary who then transfers it to the buyer.

EASEMENTS:
Grant an entity/individual the right to use (but not own) someone else’s property for a specific purpose. There are three main categories of easement, however not all categories of easement survive changes in ownership.

ESCROW:
Refers to a contractual/legal arrangement in which a third party receives and temporarily holds funds associated with a real estate transaction, until a particular condition has been met. In 1031 cases, funds are held in escrow by the Qualified Intermediary or Exchange Accommodator.

EXCHANGE ACCOMMODATION AGREEMENT:
An agreement entered into between the taxpayer and an Exchange Accommodation Titleholder (“EAT”). (See Exchange Accommodation Titleholder below.) The agreement provides that the Exchange Accommodation Titleholder will take temporary title to the taxpayer’s replacement property or relinquished property and hold it until the completion of the exchange.

EXCHANGE ACCOMODATION TITLEHOLDER (EAT):
An unrelated, disinterested, qualified party who holds legal title to the relinquished or replacement property, in order to allow time for the second half of the exchange transaction to be completed. Similar to a QI which holds exchange proceeds in escrow to prevent receipt, in a parking arrangement, an EAT does the same for title to the real property.

EXCHANGE FACILITATOR:
A broad term used to refer to individuals or other legal entities that facilitate 1031 exchanges (for e.g., Legal 1031 Exchange Services LLC). The term “Exchange Facilitator” also includes Qualified Intermediaries and Exchange Accommodation Titleholders.

EXCHANGE PERIOD:
Refers to the 180 calendar days a taxpayer has in order to complete the acquisition of the replacement properties. This period begins the first day after the transfer of the relinquished property and ends on the 180^th day following the date the relinquished property is transferred. It is important to note that the 180-day exchange period can be cut short if, before the 180^th day, the Exchanger files their tax return for the tax year of the exchange. To read more about timelines and when the exchange clock starts ticking, check out our article here.

EXCHANGE PROCEEDS:
Refers to the funds generated from the sale of the relinquished property that are eligible to be reinvested in replacement real estate. Generally, in a deferred multi-party exchange, these funds are then received and held in escrow by a Qualified Intermediary.

EXCHANGE AGREEMENT:
A written contract entered into between the exchanger and a Qualified Intermediary. The agreement defines the sale of the relinquished property, the purchase of the replacement property, and any limitations during the exchange period.

EXCHANGE CLAUSE, aka EXCHANGE COOPERATION CLAUSE:
Language added to a contract between the buyer and seller which distinguishes the transaction as a 1031 exchange. The language informs and notifies the buyer that the seller is structuring the transaction as a 1031 exchange and requests the buyer to cooperate. To read more about cooperation clauses in reverse exchanges, check out our webpage here.

EXCHANGER:
The party that is  transacting or intends on transacting a 1031 exchange, often called the “Exchanger” or “Exchangor” can be an individual or business entity (including LLCs, partnerships, corporations or trusts). The Exchanger is the ultimate tax owner of the Relinquished Property and the party that would report the deferred gain from the exchange on its tax returns.

FEE SIMPLE INTEREST:
An interest in land or real estate that is unrestricted and freely alienable. A person with a fee simple interest has complete ownership and 100% rights in the property.

FORWARD EXCHANGE,aka DELAYED EXCHANGE: 
Most 1031 exchange transactions are structured as a delayed exchange, also known as a forward exchange. In a delayed exchange the exchanger sells the relinquished property first and subsequently acquires replacement property. The exchanger must identify the potential replacement property within 45 calendar days from closing on the relinquished property and close on identified properties no later than 180 days from closing of the relinquished property.  To read more about this standard exchange structure, read our 1031 Exchange Basics and Exchange Overview on our website.

IDENTIFICATION PERIOD:
A critical deadline in the exchange timeline.  The Exchanger has 45-days from the date of the sale of the relinquished property to identify the potential replacement properties; these 45 days make up the identification period. Read more about the identification rules and identification period in our article here.

IMPROVEMENT EXCHANGE:
Allows a taxpayer to structure their 1031 exchange in a way that allows them to use proceeds from the sale of their relinquished property to not only acquire replacement property, but to make improvements to the replacement property, while still benefiting from the tax deferral benefits of a 1031 exchange. Critically however, the improvements made to the replacement property in this form of exchange must be completed within the 180-day requirement of Section 1031, otherwise any remaining improvements will be “boot” and taxed fully. It is also important to note that no prepayment of materials or labor is allowed. To read more about improvement exchanges, check out our article here.

LEVERAGING-UP:
A term used to describe increasing the amount of money/funds borrowed. Oftentimes leveraging-up is used to increase a portion of a company’s debt structure by taking on new financing and using the proceeds to expand.

LIKE-KIND PROPERTY:
Refers to properties that are of the same nature or character as each other. In an IRC §1031 exchange, both the relinquished property and replacement property must be of like kind. The relinquished property must be held for productive use in a trade or business, or for investment purposes, and be exchanged for property that is also to be held for productive use in a trade or business, or for investment purposes. IRC §1031(a)(1). Click here to go to our article on Like-Kind Exchanges.

LIMITED LIABILITY COMPANY (LLC):
Refers to a business entity, comprised of one or more individuals, in which members of the LLC cannot be held personally responsible for business debts.

NET LEASE:
While there is no universally accepted definition of a “net lease”, it generally refers to a provision within a rental agreement that requires a tenant to be responsible for the payment of all or some of the taxes, fees, and/or maintenance costs associated with the property they are renting. This form of lease reduces the amount of responsibility that falls upon the landlord. There are three subcategories to net leases:

Absolute net lease is a rental agreement wherein the tenant pays the landlord a set monthly rent amount, but the tenant also pays for all expenses associated with the property and operations of their business.

Triple net (“NNN”) lease is a rental agreement wherein, in addition to monthly rent and utilities paid to the landlord, the tenant pays all expenses of the property including real estate taxes, building insurance, and maintenance.

Double net (“NN”) lease is a rental agreement wherein, in addition to monthly rent and utilities paid to the landlord, the tenant pays 2-3 primary property expenses like taxes, utilities, and/or insurance premiums.

“OUTSIDE” MONEY:
Refers to any funds brought into the exchange from outside of the transaction. Also, referred to as “out of pocket funds.” Outside money is acceptable to bring into the exchange, as it has already been taxed as income when received. Outside money typically comes in when the Exchanger does not have enough exchange proceeds to close the transaction on replacement property.

PARKING EXCHANGE, aka REVERSE EXCHANGE:
Structured differently compared to a regular “forward” or “delayed” exchange. A valid parking arrangement prevents the exchanger from owning both the relinquished and replacement properties at the same point in time, thus preserving eligibility for an exchange. A parking arrangement is necessary when (a) an exchanger wishes to acquire the replacement property before selling the relinquished property; (b) the exchanger needs to make improvements on the replacement property before taking title to it; or (c) a combination of the above (i.e., where the exchanger acquires and improves the replacement property prior to selling the relinquished property). These are the reverse, improvement, and reverse-improvement exchanges, respectively. To read more about reverse and parking exchanges, read our article here.

PARTIAL EXCHANGE:
An exchange in which the taxpayer does not reinvest all proceeds of the sale of the relinquished property into the replacement property, causing that portion (referred to as “boot”), to be subject to capital gains tax. See Boot above.

PARTNERSHIP:
An unincorporated business entity, comprised of two or more people as partners, subject to pass-through taxation.

QUALIFIED INTERMEDIARY:
An independent escrow agent that is essential to completing a valid delayed 1031 exchange.  Basically, the IRS has disqualified from acting as an intermediary almost any person or entity who you would normally trust with your exchange funds. Some examples of disqualified parties are related persons and entities, and any person or firm that has been an employee, real estate broker, attorney, accountant, agent or investment banker or broker within two years preceding the date of transfer of the relinquished property. If the Exchanger or any one of the disqualified parties comes into receipt of exchange funds, it would void the exchange. Using a well-established Qualified Intermediary allows an Exchanger to take advantage of the “Safe Harbors” provided for in the Treasury Regulations, protecting the Exchanger against “constructive receipt” of the Exchange funds. It is also good practice to research the nature of the guaranties offered by the Qualified Intermediary. To read more about why you need a qualified intermediary before you start your exchange, check out our article here.

QUALIFIED ESCROW ACCOUNT:
Refers to an escrow account that is managed by a disinterested, qualified party.

REAL ESTATE INVESTMENT TRUSTS (REIT):
Companies that own or finance income-producing real estate across a range of property sectors. REITs are similar to mutual funds in that they allow individual investors to invest into a large, diversified pool of assets and also receive some of the favorable tax treatment provided to real estate owners.

Generally, an interest in a REIT will be considered a security, and thus fall into the exclusions enumerated in IRC §1031(a)(2). However, if structured properly, there are alternatives for taxpayers wishing to do these types of exchanges. An owner of real property can contribute real property to an “UpREIT” or “DownREIT” pursuant to IRC §721, which provides that such contribution is a non-recognition transaction.

REALIZED GAIN:
The profit which results from selling an asset at a price higher than your current adjusted basis. See Adjusted Basis above. Gain is the difference between the adjusted basis at the time of sale and the contract price less any costs of the transaction. Simply put, if you were to sell an investment property and make a profit on that sale, the profit received is the “realized gain.”

RECOGNIZED GAIN:
The profit from selling an asset, however, recognized gain is different from realized gain (defined above). Recognized gain refers to that specific portion of the realized gain that is required to be reported as income on a federal income tax return.

RELATED PARTIES:
Those parties “related” to the taxpayer as defined by §267(b) and 707(b)(1). Pursuant to these sections, the definition of “related party” includes, but is not limited to, spouses, ancestors, lineal descendants, and siblings (brothers and sisters, whole and half-blood). Among those considered not related to the taxpayer, are aunts, uncles, cousins, nieces, nephews, in-laws, ex-spouses, employees, business associates, and friends.

With regard to corporations and partnerships, an entity is considered related to the Exchanger if the Exchanger owns more than a fifty percent interest.

RELINQUISHED & REPLACEMENT PROPERTY:
In an exchange under §1031 of the Internal Revenue Code, the RELINQUISHED property is the property that the investor is selling or disposing of, whereas the new purchased property received by the taxpayer is referred to as the REPLACEMENT property.

REPAIRS:
If improvements made to a property do not add value and prolong its life, then they are considered a repair. For example, replacing the roof of a building may be considered a capital improvement; however, fixing a roof leak is considered a repair. See Capital Improvement above.

REVERSE EXCHANGE:
Takes place when the taxpayer acquires/purchases the replacement property before transferring/selling their relinquished property. The exchanging taxpayer uses a parking arrangement to prevent ownership of both properties at the same time. The reverse exchange effectively takes place after the relinquished property is sold.

SAFE HARBORS:
Provisions set by the IRS that aim to provide the taxpayer with a degree of certainty that their transaction will be valid. For example, the 1031 exchange regulations provide that utilizing a qualified intermediary and qualified escrow account to structure your exchange are “safe harbors.” See Treas. Reg. 1.1031(k)-1 (g).

SALES PRICES:
is the contract purchase price of the property, less any allowable closing costs. The sales price is also referred to as the “net sales price.”

SELLER FINANCING:
A real estate arrangement under which the seller of a property provides the buyer with the financing (usually payment of installments) needed to purchase the property, instead of the buyer obtaining traditional financing in the form of a mortgage from a bank or financial institution.

SIMULTANEOUS EXCHANGE:
The entire transaction, both the exchange of contracts and the completion of the exchange, take place on the same day – essentially, simultaneously.

STARKER EXCHANGE:
An industry term of art for a deferred 1031 Exchange.  See Starker v. United States (1979). The Court’s holding in Starker was the catalyst that led to the usage of qualified intermediaries when the deferred 1031 exchange and safe harbors were codified in the Tax Code and corresponding Treasury Regulationst.

STEPPED-UP BASIS:
Deemed by the United States Tax Code to be the fair market value of a gift at the time a benefactor dies, in a scenario when an individual receives a gift asset from a benefactor. This fair market value of the gifted asset on the date of the benefactor’s death is the “stepped-up basis.”

TAX ADVISOR:
A financial professional who generally provides tax advice to their clients, including strategies to minimize taxes, applicable regulation, etc. Some examples of tax advisors are accountants, CPAs (certified public accountants), enrolled agents, financial advisors, or tax attorneys.

TAX PARTNERSHIP:
Treated as a separate taxpayer from the individual partners and likewise real estate owned by a tax partnership is generally not considered to be owned by the individual partners. The term partnership means a business entity that is not a corporation under Treasury Regulation 301.7701-3(b) and that has at least two members.

TENANCY IN COMMON:
The co-ownership of property by two or more persons under an arrangement that is not deemed to be a partnership. A tenancy in common interest (commonly referred to as “TIC”) is a fractional ownership interest in a piece of property, rather than purchasing the entire property (“fee interest”). To read more about tenancies in common, check out our article here.

TITLE:
Refers to the legal ownership of a property, meaning that the individual or entity on title has the rights to use that property.

TITLE INSURANCE:
When you purchase or finance real estate, title insurance protects you against future claims or legal issues stemming from past problems with your property’s title—such as undiscovered liens or ownership disputes.

Legal 1031 is proud to be a subsidiary of Kensington Vanguard National Land Services, a trusted name in title insurance and real estate services. Visit their site to explore how they can help protect your real estate investments.

TRUST:
According to the IRS, a trust is defined as, “a relationship in which one person holds title to property, subject to an obligation to keep or use the property for the benefit of another. A trust is formed under state law. You may wish to consult the law of the state in which the organization is organized. Definition from IRS.gov “special types of trusts.”

WITHOLDING:

WITHOLDING CERTIFICATE: