In a 1031 exchange, the taxpayer sells and replaces real or personal property of equal or greater value within 180 calendar days of the initial closing given the property has been used and replacement will be held in the productive use of a business or for investment. The Internal Revenue Service (IRS) Code Section 1031 allows the taxpayer to indefinitely defer the federal and state capital gain and depreciation recapture taxes which can amount to forty percent of the relinquished or old property sales price. The tax is ultimately due when the replacement property is sold in a non-exchangeable transaction, or it can be deferred again in a subsequent 1031 exchange.
Net Proceeds
A Qualified Intermediary (QI) is required to accommodate a 1031 exchange when there are three or four parties involved in the transaction. The QI role is to prepare agreements in accordance with the IRS 1031 code and hold the sale net proceeds (cash due Seller) in a manner that preserves principal and liquidity to satisfy the constructive receipt (g)(6) requirements of the 1031 code. The closing company or escrow wires the net proceeds to a non-commingled escrow account under the taxpayer’s social security number or employer identification number.
Qualified Escrow Account
The number one way to protect your 1031 exchange proceeds is to use a Qualified Escrow Account (QEA). In states (California, Oregon, Washington, Colorado and Virginia) that have implemented laws to protect their residents from wayward QIs, a QEA is a recognized option in place of a one million dollar fidelity bond. A fidelity bond provides the taxpayer with recourse enabling the recovery of a portion of their 1031 exchange funds after legal fees and deductible are satisfied when the QI has defalcated or embezzled the exchange funds. The QEA is a three way agreement between the taxpayer, QI and the bank holding the net proceeds. The bank places a debit lock on the funds, meaning the net proceeds cannot move without signatures from the taxpayer and QI authorizing the disbursement.
Exchange Agreement Declaration
The second way to protect your 1031 exchange funds is for the exchange agreement, which is the primary exchange document supporting the 1031 intent to clearly state that the exchange proceeds are not the asset of the QI. Suggested language includes “QI shall hold the Exchange Account solely for the benefit of Exchangor under this Agreement and the Exchange Account shall not be deemed a part of QI’s general assets or subject to the claims of QI’s creditors.” This makes it clear that the proceeds held in the Exchange Account are not the property of the QI.
Escrow Bank
The escrow bank or institution holding the exchange funds in a QEA must maintain results of performance, growth, strength and stability, along with high ratings from Bauer Financial and Bankrate.com. Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per taxpayer. Certificate of Deposit Account Registry Service (CDARS) allows for larger balances to access multi-million dollar FDIC insurance. There is a risk of principal should the funds be needed prior to the maturity date. Banks who work with QIs holding QEAs understand the 1031 escrow requirements and have procedures and staff in place to efficiently escrow 1031 exchange funds. Another alternative is the 90 day US Treasury Bill.
Last year, Atlas 1031 Exchange was approached to hold funds in an escrow account. A check was forwarded for deposit that the bank determined to be fraudulent. Without bank procedures, Atlas 1031 could have been liable for the six figure deposit. Fortunately, the check was thoroughly screened and transaction stopped.
In preparation for engaging a QI, click here to download a series of questions the most experienced exchangors ask. Don’t decide based upon the QI fee alone; seek a Certified Exchange Specialist® who utilizes a QEA to accommodate your 1031 exchange.
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.
