A 1031 tax deferred
property exchange is an exchange by which a property owner may trade one
property for another without having to pay any federal income taxes on
the transaction.
Property owners may
sell "like-kind" properties and defer taxes on the sale's profits
if they satisfy the requirements of Internal Revenue Code (IRC) 1031 exchange.
The purpose of the 1031 Exchange is to allow sellers of like-kind property
to buy replacement property of like-kind within a specific time period
and defer taxes. When an exchange is conducted in accordance with the
Code and the Regulations, the tax on the gain which is realized by virtue
of the sale of the old property will be deferred, (not recognized) until
such time as the property acquired in the exchange is sold or otherwise
disposed of in a taxable transaction.
In an exchange, a
property owner simply transfers the old property and receives the new
property. However, the exchange must be structured in such a way that
it is, in fact, an exchange of one property for another, rather than the
sale of one property and the purchase of another. Sellers have a maximum
of 180 calendar days from the closing of the initial sale to complete
the exchange. Within the first 45 days of this period a seller must designate
candidate properties and properly identify them.
If no new
properties are identified in the first 45 days or no designated
transaction is completed during the full 180 day period, the trust
will be liquidated and the sale proceeds will be taxed at the
prevailing capital gains rate.
The basic differences
between a property sale and a property exchange are that in an exchange
the seller becomes the exchangor, and that an intermediary (like Exchange
Holding Services, Inc.) is required. Based on the regulations specified
in IRS Section 1031, an exchange intermediary is required to handle
all
monies generated by the exchange and hold them in trust until the exchange
is
completed.
The
1031 Exchange process at-a-glance:
- The exchangor
identifies the property to be exchanged and contacts a real estate
agent and a Qualified Intermediary service (like Exchange
Holding Services, Inc.).
- The Qualified Intermediary is designated by the exchangor. The exchangor and real estate
agent are instructed to write into their contract the specific language
which notifies all parties that the property being sold is part of a
tax-deferred exchange.
- The exchangor and
the Qualified Intermediary sign an additional contract which details
rights and responsibilities of all parties involved in the exchange.
This contract identifies the relinquished property, clarifies deadlines
for identifying replacement property and purchase of replacement property
and rights of arbitration.
- At the time a
buyer is confirmed and the contract is signed, the closing attorney or
escrow officer, schedules a date for the closing. The Qualified Intermediary
service sends written instructions to the closing attorney or escrow
officer, describing the intermediary relationship and provides the Exchange
Agreement to be signed by the Exchangor and the Qualified Intermediary.
- The Qualified Intermediary
service receives the proceeds from the relinquished property. The funds
are deposited in an interest bearing account.
- The exchangor is
required to identify the replacement property within 45 days after sale
of the relinquished property and notifies the Qualified Intermediary
service or another party involved in the exchange, in a written document.
Replacement property must be purchased within 180 days after the sale
of the relinquished property.
- The Qualified Intermediary service is notified by the Exchangor when his/her property
is in escrow (or is notified by the closing attorney when there is no
escrow). The Qualified Intermediary prepares the second phase of documents
and provides them to the escrow officer (or the closing attorney). The
Exchangor signs the phase two documents. Funds are requested to be sent
from the intermediary to the escrow company (or to the closing attorney's
trust account), just prior to the closing date.
- The closing is
completed and the transaction records on or before the 180 days after
the closing of the relinquished property.
