An Internal Revenue Code section 1031 exchange allows for the deferment of capital gains taxes on the exchange of “like kind” property that is held for use in trade, business or investment. For example, if a rental property owner is moving and would like to sell his rental property in his current location, he can use the funds to buy new rental property in his new location, he could use a 1031 exchange to defer paying capital gains taxes on any appreciation in value the property experienced. If the property had depreciated and is selling for less than the purchase price, a 1031 exchange would defer the loss. If not all the funds are used to purchase the new property as in a partial 1031 exchange they will be taxed. “Like kind” property means that the properties exchanged are of the same nature or character. Foreign property is not considered “like kind” to property in the United States. Certain items, such as primary residence, inventory, partnership interests, indebtedness and stocks are explicitly ineligible for 1031 consideration.
Unless the exchange is between two parties each wanting one another’s properties, a 1031 exchange requires that a Qualified Intermediary is engaged. Because a Qualified Intermediary is required to have no business or familial relationship to the taxpayer, they are usually a company whose sole business is facilitating such exchanges. They hold all the funds from the sale until purchasing the new property. This ensures that the taxpayer does not have access to the funds to benefit from them. Qualified Intermediaries must follow all pertinent regulations and appropriately draft required paperwork to ensure the exchange qualifies. For this reason it is ideal that they have a background in tax law. They should also be bonded in case of any errors or omissions that result in a financial loss to the taxpayer. A 1031 exchange using a Qualified Intermediary would generally proceed as follows:
The taxpayer sells the property, including a clause to ensure the cooperation of the buyer in the exchange. Inclusion of this clause also provides proof that the 1031 exchange was in place at the time the deal was closed. The funds are held in escrow.
The taxpayer enters into an exchange agreement with the Qualified Intermediary defining the 1031 requirements to complete the 1031 exchange. The Qualified Intermediary is also assigned the rights rather than the obligation of the Purchase and Sale Agreement.
The escrow is established and the intermediary places the funds in a safe, liquid, segregated money market account. Typically a qualified escrow account is created requiring dual signatures with one of those from the taxpayer authorizing disbursement.
The taxpayer identifies the replacement property and officially notifies the Qualified Intermediary in writing within 45 days of the initial first leg closing.
An agreement to purchase the replacement property with a clause ensuring the cooperation of the seller in completing the 1031 exchange is put in place. The Qualified Intermediary is again assigned the rights in assignment of the Purchase and Sale Agreement.
Once the stipulations of the exchange are satisfied the Qualified Intermediary forwards the exchange agreements to the title or escrow company for signature along with exchange funds. This must be done within 180 days of the closing of the first escrow.
The taxpayer files Form 8824 with their federal tax return in the year the old or relinquished property was closed.
In both the selling of the property and the purchase of its replacement, the warranty deed is conveyed directly from and to the taxpayer. The primary role of the Qualified Intermediary is to prepare the 1031 exchange agreements in accordance with the Internal Revenue Code Section 1031 and hold the exchange funds under the taxpayer’s tax identification number.
To learn more about what ten items to consider when initiating a 1031 exchange, click the button below to receive the free “Ten Point 1031 Checklist.”
