Taxpayers who wish to initiate a tax deferral may ask “What are the initial 1031 exchange steps?” in an effort to avoid any mistakes. As a Qualified Intermediary (QI) of 1031 exchanges, I appreciate the question because it shows the taxpayer is taking ownership. With ownership comes better questions and clarity, resulting in fewer if any misinterpretations.
CPA Input
The suggested first step is to review with your CPA or accountant the tax consequences of selling the property. Given the taxpayer’s intent is to replace with property with equal or greater value and a federal and state capital gains or recaptured depreciation tax is triggered, then most likely it makes sense to initiate a 1031 exchange. Understanding the tax consequences is important and provides a value to the exchange. The value or tax deferral represents an indefinite interest free loan due when the replacement property is sold, unless another 1031 exchange is initiated.
Engaging the QI
Once you know that it makes sense to defer the capital gain or recaptured depreciation, then it is time to engage a QI. By engaging now, rather than once the Purchase and Sale Agreement (PSA) is signed, you allow for time for the QI to respond to questions. To help vet prospective QIs, download a white paper containing four questions typically only the seasoned 1031 exchangor asks. QIs accommodate exchanges across the United States and worldwide. It is not necessary to engage a QI located in your state. It is important though that the QI complies with state QI regulations in Washington, Oregon, California, Nevada, Idaho, Colorado, Virginia and Maine. You can also review the following two articles that provide a summary of those QI requirements.
- California, Colorado, Idaho and Maine 1031 Exchange State Laws
- Nevada, Oregon, Virginia and Washington 1031 Exchange State Laws
The QI will create, under your tax identification number, the escrow account to hold the exchange funds. The Prudent Investor Standard should be used by the QI to ensure account liquidity and preservation of principal.
Selling the Relinquished Property
Selling the old or relinquished property is the next step unless the decision is to acquire the replacement property first. There are many different types of exchanges, but each is either a forward or reverse. A forward 1031 exchange is when the relinquished property is sold first, followed by the replacement property purchase. A reverse 1031 exchange allows the replacement property to be acquired before the sale of the relinquished property.
The take away point is to include assignment language in the PSA. As part of every 1031 exchange, the rights to the PSA, not the obligations, are assigned to the QI. In a forward exchange, this allows the QI to receive the net proceeds or exchange funds to hold in the escrow account towards the replacement property purchase. The relinquished property is deeded directly to the Buyer. In the replacement property PSA, assignment language is required because the Seller must approve of the assignment of the PSA rights to the QI. At the replacement property closing, the assignment of the rights to the QI allows the QI to use the exchange funds towards the purchase on behalf of the taxpayer. A 1031 exchange is composed of interdependent steps to qualify for the tax-deferred treatment under Internal Revenue Code Section 1031 and the Treasury Regulations.
The Florida Realtor PSA has 1031 language already embedded on line 439. The assignment language can be added either as an addendum or in the space available before the signature blocks.
In either a forward or reverse exchange, the replacement or relinquished property PSA can be in place or signed before the first leg closing of either exchange.
In those transactions where an earnest money deposit (EMD) is not held by an escrow company, as long as the deposit is returned at closing to be included in the exchange funds, a tax is not imposed. If the EMD is kept, then a tax is triggered.
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