Explaining the 1031 Exchange

We want to help make your real estate transactions as economical and as efficient as possible. That's why we believe that the tax deferred exchange is an approach that should be considered by anyone who owns investment or business related property. Here's how it works.

Whenever you sell business or investment property and have a gain, you generally have to pay tax on the gain. Internal Revenue Code Section 1031 lets you defer the capital gains tax by exchanging the sold property for other like-kind property. You can defer or delay the payment of the tax that would normally be due on the sale until sometime in the future.

1031 Exchanges are often called “tax free exchanges”, because the exchange itself is not taxed. Tax deferred exchanges are best known for their application to real property exchanges. However, most property, both personal and real, will qualify for an exchange. This includes investment grade art, stamp and coin collections, antique automobiles, and antique furniture. A tax deferred exchange may also include business assets such as trucks, airplanes, or fishing boats, or the business itself.

Three requirements must be satisfied in order to qualify for tax deferral under Section 1031: (1) the transaction must be an exchange; (2) the exchange must involve like-kind properties; and (3) both the properties transferred and the properties received must be held either for productive use in a trade or business or for investment.

Tax deferred exchanges are both practical and easy to accomplish. IRS guidelines (April, 1991) allow you to sell your property and have 180 days to buy a replacement property. However, Section 1031 does attach strict rules that you must follow if the tax due from the sale is to be deferred. By using a Qualified Intermediary, tax deferred exchanges are relatively simple, hassle-free and safe.

Following are answers to the most frequently asked questions pertaining to 1031 Tax Exchange.

Does vacation property qualify for a 1031 exchange?

We know that a 1031 exchange must involve like kind properties, and both the properties transferred and the properties received must be held for productive use in a trade or business, or for investment.  But that's as far as the written definition goes. So it's logical to ask if vacation property is indeed eligible. 

In Private Letter Rulings, the IRS has allowed for Section 1031 where the taxpayer intended to acquire property for personal enjoyment and as an investment. One P.L.R. stated, The house and lot you acquire in this trade will be held for the same purposes as the properties exchange: to provide for personal enjoyment and to make a sound real estate investment. We can read that personal enjoyment of vacation property does not prevent it from being eligible for the advantages of Section 1031.

Can I ever live in a property purchased for investment under a 1031 exchange?      

Yes, provided that you use the property for investment for a period of time, you can later use the property for personal use. The specific initial  investment  use period is not referred to expressly in the code, however it is largely accepted that a 2-3 year holding period is adequate after which time a property for investment under 1031 may be used in any manner the owner desires.   

If I sell some farmland I own, can I purchase a rental condo at the beach or in the mountains for my replacement property?      

Yes, as long as the replacement property is equal to or greater than the value of the property you sold. Under this arrangement, it would be important that you use the condo as investment property, which means limiting you personal use to 14 days per year.

If I have $100,000 from the sale of my relinquished property, how much replacement property could I purchase?   

You can purchase as much property as you can leverage provided that you use the entire $100,000 of relinquished funds. For example, you might buy $1,000,000 in replacement property with 10% ($100,000) down.

Do I need a Qualified Intermediary?      

IRS regulations and court cases have established that, in a delayed exchange, there needs to be an independent third party holding the proceeds of the sale of the relinquished property. The Qualified Intermediary cannot be an agent of either the seller or the buyer of the property. Most often, the Qualified Intermediary is an accommodator company which specializes in this form of transaction.  

Why not leave the money in escrow with instructions not to disburse until a replacement property is located?   

The escrow is not an independent third party. It is neutral only in the sense that it is a bilateral agency in which all parties give the agent instructions. Instructing the escrow to keep the money is actually constructive receipt by the Exchanger, and disqualifies the exchange. 

Who may serve as the Qualified Intermediary?   

Anyone who is not disqualified may serve as the accommodator (Qualified Intermediary) to facilitate the exchange. The rules disqualify related parties (close family members and controlled business entities) and agents such as the real estate broker and the Exchangor's attorney and accountant. Accommodator companies, unrelated persons, even someone else's attorney or accountant, are eligible to serve. The Exchangor should evaluate his needs and consider the risks before deciding on the best opinion.   

How can I be sure my money is going to be safe with the Qualified Intermediary?    

There are several security devices. Most common is a guarantee from a better-funded company. (All accommodators are shell corporations. The only question is what steps have been taken to provide security for their clients.) Other options including bonding, or a qualified escrow trust.   

Do I have to deposit all monies from the sale of the relinquished property with the qualified intermediary? 

No. There are means by which some of the cash may be left in Escrow to be disbursed by the Exchangor. However, this needs to be arranged with the Qualified Intermediary in advance. Once the funds have been deposited into the Qualified Escrow Account, the Qualified Intermediary must keep it to be used only for the purpose of purchasing Replacement Property. If any funds are withdrawn otherwise, this represents control by the Exchangor and will disqualify the exchange.   

If the exchange is canceled or if money is left over after some of the replacement property is acquired, may I get the money back, and when?   

Most exchange agreements allow for the money to be returned under the following circumstances: 

• After forty-five (45) days have elapsed, if no Replacement Property has been identified; 
• After all property to be acquired has been acquired; 
• If there is a contingency provided for in writing which is beyond the control of the Exchangor and it prevents the completion of the exchange, and;  
• After the 180th day of the exchange  

Can the money be held at Interest?   

Yes, most Qualified Intermediaries will offer to pay interest on the monies being held in the Escrow. The interest paid will be taxable to the Exchangor as interest income. The interest cannot be paid until the Replacement Property has been acquired or one of the other conditions mentioned in the previous question has been met.   

Can Earnest Money or other expenses be paid from the proceeds held by the qualified intermediary?      

Yes. These payments must be paid to the person or entity requiring them and must be customary exchange closing costs.  

Who signs the earnest money agreements and/or the purchase contracts?   

Generally, the Exchangor will sign the earnest money agreements and/or purchase contracts and later assign it to the Qualified Intermediary.   

When should the qualified intermediary begin to participate in the exchange?   

When the Exchangor is certain there will be a closing of the Relinquished Property, he/she should contact the Qualified Intermediary to begin the necessary document preparation. It is also necessary to have the Qualified Intermediary be a party to the escrow, so the Exchangor should not wait until the last minute to employ a Qualified Intermediary's services.  

Who signs the escrow instructions and transaction documents?   

The Qualified Intermediary must be named as seller of the Relinquished Property and as the buyer  of the Replacement Property. Therefore, the Qualified Intermediary should sign all documents necessary for the sale and purchase, except for the deed. Most exchange documentation will provide for direct dealing.  The Qualified Intermediary will require the approval of the Exchangor and may delay signing until the Exchangor approves the form of the transaction. 

What if a loan is necessary to acquire the replacement property?    

The Exchangor will need to qualify for the load. If the loan is from a bank, the trust deed will be signed by the Exchangor and recorded after the exchange is complete. If the loan is purchase money  loan form the seller of the Replacement, it is common to have the Qualified Intermediary sign, or at least participate in the loan documentation. 

What language should be on the purchase agreement?      

It is a good idea to have a cooperation clause written into the Purchase Agreement or an addendum to same. Following is a sample of this language: 

"It is acknowledged and agreed by the parties that the Buyer/Seller is entering into this contract for the purposes of accomplishing a like-kind exchange under IRS Code 1031 in conjunction with the sale of Buyer's/Seller's property, and that Buyer/Seller will make all necessary arrangements, pay all additional closing costs, and bear all other expenses and risks necessary to accomplish this exchange." 

Exchange First, a Winston-Salem, North Carolina based 1031 qualified intermediary, has provided much of the information contained herein. This information is offered as a service and is not intended to take the place of advice from a tax attorney or CPA. Those considering the possibility of a 1031 exchange should consult with their tax adviser.