An Overview for Section 1031 Exchanges
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
The 1031 Exchange Process
Section 1031 of the Internal Revenue Code provides that no gain or loss will be recognized when property held for productive use in business or for investment, is exchanged for like-kind property that will also be held for productive use in business or for investment. Put simply, in a 1031 exchange transaction, the seller of qualified property can use the entire equity in the property to purchase a Replacement Property and defer capital gain and depreciation taxes.
To fully defer all taxes, the “Exchanger” must accomplish two things:
- Reinvest all Net Proceeds (as defined below) realized from the sale of the Relinquished Property into the Replacement Properties.
- Reacquire debt equal to or greater than the debt paid off from the Relinquished Property (or replace with fresh cash).
- Get Advice – Talk with your attorney or tax advisor to determine whether a 1031 Exchange is best for you.
- Hire an Investment Sales Broker – Contract a professional broker to market your property for sale. A professional broker will work with you to market the property, to the maximum potential buyers and facilitate the sale of the property for the maximum sale price, at the most desirable terms.
Select a Qualified Intermediary– The 1031 Exchange guidelines require that the investor use an independent third party, commonly known as a Qualified Intermediary or “QI”, to handle the funds of the exchange transaction and to facilitate the exchange. Qualified Intermediaries typically include banks, law firms and specifically incorporated Qualified Intermediary firms.
Once you have identified a Qualified Intermediary, you will enter into an Exchange Agreement with the QI. This agreement will allow the QI to receive the funds from the sale of your Relinquished property, hold those funds in escrow, and then eventually use them to purchase your Replacement property.
In order to receive the tax-deferment benefits of a 1031 exchange, you must not have direct control over the funds from the sale of your relinquished property, otherwise the IRS will not recognize the sale and subsequent purchase as a 1031 exchange.
- Purchase Agreement executed to sell the Relinquished Property – The Purchase & Sale Agreement is completed just as you would a regular sale except specific language is included stating that you intend to execute a 1031 Tax Deferred Exchange and that the Buyer agrees that the Seller may assign the Seller’s rights to a Qualified Intermediary to facilitate the 1031 Exchange.
- Closing on the Relinquished Property – At closing you will sign the 1031 Exchange documents provided by the QI in addition to the sale closing documents. The QI will hold the sale funds in an interest-bearing account until the Replacement Property is acquired.
- Identify the Replacement Property – The identification rules in a 1031 Exchange include the following:
- The 45 Day Identification Rule – The IRS 1031 Exchange requires that the Replacement Property be identified no later than 45 days following the closing of the Relinquished Property.
- The 3 Property Rule – You may identify up to three potential replacement properties regardless of their fair market value.
- The 200% Rule – You may identify more than three potential replacement properties so long as the total fair market value of your identified properties does not exceed 200% of the sale price of your relinquished property.
- The 95% Rule – If you choose this option, then you must purchase enough replacement property to equal at least 95% of the fair market value of the identified properties.
- Remember: The replacement property/properties should have a fair market value greater than or equal to your relinquished property in order for the exchange to be completely tax-deferred.
- Remember: You must provide detailed information on the Replacement Property including the street address and name of the property in your written identification to your QI within the 45-day period.
- Purchase Agreement and Closing of Replacement Property – The next step is to enter into a Purchase Agreement with the seller of your Replacement Property. This Purchase Agreement should include specific 1031 language, similar to the Purchase & Sale Agreement, for your Relinquished Property. Your QI will, according to your Exchange Agreement, use the funds it received from the sale of your Relinquished property to buy the Replacement property. The seller will deed the property to you, receive payment from the intermediary, and you will receive your replacement property.
- Acquiring the Replacement Property
- The 180 Day Rule – The Seller is allowed up to 180 days from the closing of the relinquished property to complete the purchase of the replacement property so long as the replacement property has been identified within 45 days.
- File IRS Form 8824 – After you complete the exchange, in order to receive the tax-deferment benefit of the exchange, you must complete and file IRS Form 8824-Like-Kind Exchanges-in the tax year in which the exchange occurred.
Susan bought an investment property for $300,000 several years ago and put an additional $100,000 into capital improvements. Her basis is now $400,000. Susan enters into a contract of sale for $600,000. Her capital gain would be $200,000, which, assuming a capital gains tax rate of 23.8%, would mean a $47,600 tax bill. To defer paying this tax, Susan engages a Qualified Intermediary to assist in structuring her sale, as the first leg of a 1031 exchange. If Susan wants to defer all gains from the sale of the Relinquished Property, at closing, all of Susan’s Net Proceeds are paid by the buyer or closing agent directly to the QI. The funds are deposited into a segregated escrow account, controlled solely by the QI. Within 45 days after the date of the closing of the Relinquished Property, Susan identifies in writing, the replacement properties and sends them to her QI. Within 180 days of the sale of the Relinquished Property, Susan directs the QI to fund her purchase of one of the Replacement Properties. If there are any remaining funds held by the QI, they are paid over to Susan. Such non-reinvested funds (which are boot) are subject to capital gains tax.