What is a 1031 Exchange?
A “Like Kind Exchange” under Internal Revenue Code §1031 can be used by a seller of real property to defer, and in some cases avoid, the payment of income taxes that would be currently due if the sale resulted in a gain for the seller. A seller is normally obligated to report as income any gain derived from the sale of real property in the tax year that the sale was completed. §1031 makes an exception to this requirement. In general, §1031 provides that no gain or loss is recognized where real property that was held for business use or for investment purposes is exchanged for like kind property.
Exchanges under §1031 are common, but they are also complex and difficult. A primary reason for the difficulty is that it is rare for a seller to find a buyer who has qualified real property to exchange or, for that matter, who even wishes to be involved in any manner with an exchange under §1031. The most common method of avoiding this problem is through the use of qualified intermediaries in the manner described in IRS regulation 1.1031 (k)-1(g)(4).
1031 EXCHANGE IN A NUTSHELL
In a nutshell, a 1031 Exchange transaction is a way for owners of business and investment Real Estate to sell their property and buy other like kind property without paying the Capital Gains Tax. These transactions are known as deferred exchanges, or 1031 exchanges, and allow the investor to continue his investment in another property without loosing investment equity to taxes. The rules also required certain time limits and other requirements, all of which can be found in the Quick 1031 Reference Guide.
The only practical safe harbor for most "Exchangers" is a "Qualified Intermediary." National Granite 1031 Services is a qualified intermediary and is set up to assist you in making a smooth and easy exchange. You can call us toll-free at 888.GET.1031 or get in touch via the Contact form.
How a 1031 Exchange is Accomplished
Retain the services of tax counsel/CPA. Become advised by same.
Sell the property, including the Cooperation Clause in the sales agreement. "Buyer is aware that the seller's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer." Make sure your escrow closing agent contacts the Qualified Intermediary to order the exchange documents.
Enter into a 1031 exchange agreement with your Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of your relinquished property and the subsequent purchase of your replacement property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.
The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days and the identified replacement property must be acquired by the taxpayer within 180 days.
The taxpayer sends written identification of the address or legal description of the replacement property to the QI, on or before Day 45 of the exchange. It must be signed by everyone who signed the exchange agreement, and it may be faxed, hand delivered, or mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney. Send it via certified mail, return receipt requested. You will then have proof of receipt from a government agency.
Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. "Seller is aware that the buyer's intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller." An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and growth proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.
A 1031 SCENERIO
In 1995, Bob bought an apartment in Westchester County for $150,000 that was his principal residence until his employer transferred him to San Diego in 2003. Instead of selling his apartment, Bob leased it for a two year period ending on July 31, 2005. Bob has found a buyer who will pay $450,000 for the apartment and close in September 2005. Bob plans to use the sale proceeds to buy an apartment in San Diego that he plans to rent out. Bob wants to avoid paying income tax on his $300,000 profit, and he asks you if he can do a “tax free exchange.” How do you answer him?
The Answer: We have not given you enough facts to answer Bob’s question. However, you should consider the following:
1. First, you must take Section 121 of the Code into account. Section 121 says that a taxpayer may exclude $250,000 of gain on the sale of a personal residence, if the taxpayer owned and used the property as a personal residence for at least two years out of the five year period ending with the sale. Bob can take full advantage of Section 121, because he used the apartment as his personal residence for at least two years out of the five year period preceding the sale. Section 121 does not say that the taxpayer has to be using the property as a personal residence at the time of sale. Bob, however, may still defer paying tax on any gain above $250,000 by engaging in an exchange under Section 1031 of the code.
2. Second, you must determine Bob’s actual gain. If Bob’s gain is only $250,000, then there is no reason to do an exchange. Even though Bob is selling his apartment for $300,000 more than he paid for it, he may be realizing a gain of less than $300,000. Other factors besides purchase and sale prices affect the amount of the gain. For example, if Bob took depreciation deductions during the period that he leased the apartment, then that will increase his gain. If Bob incurs expenses on the sale such as broker’s fees, attorney fees, and transfer taxes, then that will reduce the gain.
3. Third, you must determine the cost of the replacement apartment in San Diego. If the San Diego apartment costs less than $450,000, then Bob most likely will be getting some cash out of the sale, and he must pay income tax on any cash received. For example, if Bob walks out of the Westchester closing with $450,000 and buys the San Diego apartment for $400,000, then he has kept $50,000 from the sale and not used it to buy the San Diego apartment. Because only $50,000 of the gain needs to be sheltered and because Bob cannot shelter the $50,000 in cash that he received at the Westchester closing, then engaging in a 1031 exchange would be fruitless and silly.