- The Rules of the Exchange
- The Role of the Qualified Intermediary
- Timing and Maximizing Tax Deferment
- 1031 Exchange Transaction
For more than a century, real estate investors have avoided capital gains taxes by taking the proceeds of a commercial property sale and investing them in a new property. This strategy has become increasingly popular recently given the unexpected spike in real estate sale prices and many investors having to deal with significant capital gains tax implications. While these exchanges, commonly referred to as 1031 exchanges, can be fairly straightforward, there are rules that must be followed to ensure the transactions qualify for tax deferment. In this article, we will look at the rules that an investor must follow to qualify for tax deferral, and the role of the qualified intermediary.
The Rules of the Exchange
IRC Sec. 1031 states, “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
According to the IRC statute, any property that is used in business or for investment can be exchanged for any other type of property that is also used in business or for investment. For example, the statute doesn’t require that you exchange a rental property for a duplicate rental property: You can choose a replacement property of any kind, as long as it is used in business or for investment.
The various types of properties that qualify include:
- Multifamily property
- Single-family rental/condominium
- Shopping center/strip mall
- Vacant land
- Industrial/warehouse
- Office/retail
- Agricultural/timberland
- Existing leasehold interest 30 years+
- Easements
- Single tenant, triple net leased
- Beneficial interest in a Delaware Statutory Trust (DST)
- Tenancy in common interest
Since the TCJA passed, real property that is held primarily for sale no longer qualifies for a Section 1031 exchange tax deferment. To qualify for tax deferment, a transaction must be structured as an exchange of one property for another as distinguished from a sale followed by a purchase. This means the taxpayer may not actually or constructively receive the proceeds of sale.
The Role of the Qualified Intermediary
To ensure the investor does not have access to the funds, the IRS carved out a safe harbor, allowing the investor to use a qualified intermediary (QI) to hold the funds during the exchange period and facilitate the relinquishment and subsequent replacement purchase as a representative of the investor.
Prior to closing on the sale of relinquished property, the investor should execute the following documents to ensure the legitimacy of the exchange:
- An exchange agreement with a QI
- A trust, escrow, or bank account agreement with a trustee/escrowee/depository
institution
- An assignment of taxpayer’s rights under the purchase and sale agreement to the QI
By assigning the rights to the QI, the investor is tasking the QI with acquiring and transferring the relinquished property from the investor to the third-party purchaser. This keeps the investor at arm’s length from the transaction and from accessing funds.
Timing and Maximizing Tax Deferment
From the moment the initial property is transferred, the investor has 45 days to identify a property or properties to purchase with the proceeds from the sale of the initial property.
The investor must then officially notify the QI of the chosen replacement property by a written document that is signed by the investor and sent before the end of the identification period. In addition to the identification timeline, the investor also must consummate the purchase of the replacement property within 180 days of the closing of the initial property.
To maximize the tax deferment, the investor must purchase a property equal to or greater than the amount realized from the sale of the relinquished property. If, in fact, after the QI completes the purchase of the replacement property there are funds remaining in the account, they will be returned to the investor. These remaining funds are called “boot,” and they are subject to capital gains tax.
If the investor fails to identify a property within the mandatory 45-day period or fails to consummate the purchase of the property within the required 180-day period, the QI must return the funds to the investor who will then be subject to the capital gains tax.
1031 Exchange Transaction
Meeting the requirements of a 1031 exchange is complex and not within the purview of a real estate agent or a title company. Make sure to consult with an attorney that is educated in the rules so that you can be guided properly during the transaction process.
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