A 1031 exchange allows taxpayers owning real and personal property in a trade, business or investment to defer the federal and state capital gain and depreciation recapture taxes when selling and replacing with like-kind real and personal property. The tax deferral postpones the tax payment until the replacement property is sold and the taxpayer cashes out. Should the taxpayer elect to initiate another 1031 exchange, the tax deferral continues. The tax does not go away,but rather is postponed given the replacement property has a purchase price equal to or greater than the relinquished or old property. Should the taxpayer replace less than the relinquished net selling price, then a tax is triggered on the difference, known as a partial exchange. The premise for the 1031 exchange is that the taxpayer’s economic position has not changed from the sale to the purchase; no benefit is received such as cash or reduction in debt. There are many rules to follow in a 1031 exchange, including the use of an independent, third party known as a Qualified Intermediary (QI), to accommodate the 1031 exchange.
Internal Revenue Code Section 1031
In a 1031 exchange, there are a series of interdependent steps facilitated by the QI for the benefit of the taxpayer. In the typical two property forward exchange, the taxpayer enters into a Purchase and Sale Agreement (PSA) for the relinquished property. An earnest money deposit is deposited with escrow to support the Buyer’s intent to purchase. At the closing where title is conveyed from the taxpayer to the buyer, also known as the first of two legs to the 1031 exchange, the title company, closing attorney or escrow assembles the selling and buying expenses, loans and disbursement of funds received, finalizing with a warranty deed to be recorded with the County Clerk of Courts.
The QI provides settlement statement instructions so the HUD or final statement reflects a 1031 exchange. In addition, the QI drafts exchange agreements in accordance with the current Internal Revenue Service 1031 rules and regulations.
Assignment
In a 1031 exchange, the QI is assigned the rights, not the obligation, to the PSA. In effect, the QI, without taking title, is selling the property and receiving the net equity to hold in a bank as a fiduciary under the taxpayer’s tax identification number. When the taxpayer is buying, the PSA is assigned to the QI to then purchase the replacement property for the benefit of the taxpayer. One of the requirements of the 1031 code is that all parties associated with the transaction must receive the notice of the assignment in writing. This starts in the PSA when the property is sold and replacement property is acquired. The following is an example of assignment language to include in the PSA or addendum.
Selling
“Buyer is aware that Seller has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Seller requests Buyer’s cooperation in the event of an exchange and agrees to the assignment of this contract to Atlas 1031 Exchange, LLC by the Seller. Seller agrees to hold the Buyer harmless from any and all claims, liabilities and costs of such an exchange.”
Buying
“Seller is aware that Buyer has the option to qualify this transaction as an Internal Revenue Code Section 1031 tax deferred exchange. Buyer requests Seller’s cooperation in the event of an exchange and agrees to the assignment of this contract to Atlas 1031 Exchange, LLC by the Buyer. Buyer agrees to hold the Seller harmless from any and all claims, liabilities and costs of such an exchange.”
Many Realtor Association state PSAs have the 1031 language already embedded or a check box before the signatures. By informing the buyer and escrow or title closing company, they are aware the transaction may be a 1031 exchange. Is it a requirement when selling? No. The reason is that when selling, the Seller has the right to assign the contract without the written permission of the Buyer. When buying, the assignment language in the PSA is a requirement because the Seller’s approval is required to assign the rights of the PSA.
On or before the closing, Assignment and Notice of Assignment Agreements are prepared by the QI for the taxpayer and the Buyer/Seller to sign. Without these two documents, the exchange is outside the safe harbor and at risk of being disallowed. Co-sellers and co-buyers also need to be informed.
To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click on the link here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
