A 1031 exchange requires a taxpayer who is subject to US federal capital gain tax and owns real or personal property held in the productive use of a trade, business or for investment. Once determined that the property sale results in a federal capital gain or depreciation recapture, the decision is whether or not the taxpayer pays the tax or defers in a 1031 exchange. The deferral is dependent upon acquiring “like-kind” replacement property of equal or greater value and doing so by following 1031 exchange rules. Given the intent to replace, it is time to engage a Qualified Intermediary (QI) to discuss the transaction and 1031 exchange.
1031 Exchange Example
Jane owns a ranch in Colorado and raises cattle. She lives on the ranch and wants to relocate to Texas to be closer to her sisters and mother. She is a US taxpayer and the ranch will sell for more than originally paid. She talks with her CPA to confirm the tax consequences and elects to initiate a 1031 exchange by engaging a 1031 QI.
In this transaction, Jane sells a primary residence that is not a part of the 1031 exchange, but the ranch is real property held in the productive use of a business. The rule of thumb when selling a mixed use property is to determine the acreage or area surrounding the primary residence as the grass typically cut in the spring and summer months. The primary can be on a separate settlement statement or a separate line item on one settlement statement. Cash received by Seller represents those proceeds subject to the Section 121 $250,000 for an individual filing or $500,000 for married filing jointly. The ranch property line item represents the gross sales value of the ranch. Line 506 or so will include the term “1031 Exchange Proceeds” with the net amount of sales proceeds after expenses. These funds will be wired to Jane’s escrow account established by the QI to hold the proceeds for use towards the acquisition of the replacement property. Given Jane acquires the replacement property the same week, the cattle are transported to the Texas ranch and not included in the 1031 exchange. The house on the Texas ranch is acquired as her primary residence while the land and improvements represent the replacement property for her 1031 exchange.
Qualified Intermediary Vetting
In a three or four party 1031 exchange, a QI is required. In a two party 1031 exchange, or pure exchange, a QI is not required but suggested. The QI is responsible for holding the taxpayer’s exchange proceeds in a safe, liquid account that may or may not be interest bearing. The taxpayer cannot touch nor have direct access except through the QI to the exchange proceeds. If deemed the taxpayer does have control of the exchange proceeds, the exchange is over, violating the g(6) constructive receipt statute of the Internal Revenue Code (IRC). The QI prepares agreements in accordance with the IRC regulations, supporting the taxpayer’s intent to initiate a 1031 exchange.
Engaging the right QI is critically important. Each exchange is different though either a forward or reverse 1031 exchange. The right QI shall hold all exchange funds in a manner that provides liquidity and preserves principal and follows the “Prudent Investor Standard” as defined in the Federation of Exchange Accommodators Code of Ethics, Article VI, paragraph A. Qualified Escrow Agreements represent the best form of protection requiring dual signatures for disbursements, one from both the taxpayer and the QI for disbursements. A list of questions that experienced investors and corporations ask is available by clicking on the button below. Get to know who your QI is, where they are located, their procedures and most of all their experience level with the type of exchange contemplated. The QI should make the experience delightful and easy.
