A taxpayer who wishes to avoid paying capital gains taxes on the sale of real property may choose to enter into a Section 1031 Exchange transaction in lieu of a traditional sale. A transaction that meets all of the requirements for a Section 1031 Exchange will result in a deferral of federal and state capital gains and depreciation recapture tax that would otherwise be due on the realized gain. To qualify for Section 1031 treatment a transaction must meet several requirements or rules.
Section 1031 Exchange Rules
A partial summary of exchange rules follows.
- The property must be held for productive use in a trade, business or investment.
- The tax return who sells the old or relinquished property must be the taxpayer who acquires the replacement property.
- Related party rules must be followed when selling or buying from grandparents, parents, siblings or related entities.
- Replacement property must be formally identified, ideally to the Qualified Intermediary, or QI, no later than 11:59 PM on the 45th calendar day post-closing.
- The transaction must be completed within 180 days.
- The relinquished and replacement real or personal properties must be “like-kind.”
- To defer the gain, the replacement property must be equal to or greater than the relinquished property or a tax is triggered on the difference.
- IRS Form 8824 Like-Kind Exchange must be filed with taxpayer’s federal return in the year following the completion of the exchange
- The transaction must be facilitated by a QI who is not considered an agent or disqualified person, with the lone exception of a two party or pure exchange.
Qualified Intermediary Role
The role of a QI in a Section 1031 Exchange is critically important. The deferral of any capital gains tax due is predicated on the fact that the transaction is an exchange instead of an actual sale. Therefore, the taxpayer can never take actual or constructive possession of funds paid for the relinquished property. In essence, for a transaction to qualify for a Section 1031 Exchange, the taxpayer must use a neutral third party to handle the exchange of funds and preparation of the appropriate exchange documentation. This is why a QI is needed.
A QI is someone who has specialized knowledge, training and experience in handling Section 1031 transactions. Although the basic principles behind a 1031 Exchange are simple enough, the actual transactions can be extremely complex. This is particularly true if the taxpayer plans to enter into one of the specialized 1031 Exchange transactions, such as a “build-to-suit,” “improvement” or “construction” exchange. In short, this type of exchange allows a taxpayer to relinquish a property and replace that property by constructing a new building or improvements according to the taxpayer’s specifications. When prepared properly, a construction exchange can provide a taxpayer with a custom built structure and a significant tax savings.
Because a taxpayer in any type of Section 1031 Exchange must rely heavily on the QI chosen for the transaction, a QI is held to a high standard of care and is considered to have a fiduciary duty to the taxpayer. What happens though if a QI breaches that standard of care and fails to perform the QI duties as expected? Just as with other professionals, such as doctors or lawyers, a QI can be sued for breach of contract or negligence. The recently decided case of Kreisers, Inc. v. First Dakota Title Limited Partnership (Circuit Court, Second Judicial District, S. Dakota, 07/10/2013) offers an excellent example of how courts analyze and decide a case alleging negligence on the part of a QI.
This is a two part series with a review of the Tax Court case in the following article. To learn the four questions to ask when vetting a QI, click here to instantly download the free Adobe Acrobat PDF file.
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.
