The 1031 Exchange – Essentials

The 1031 Starker exchange, gives the owner of the right to sell a property and buy a similar one, by deferring capital gains tax and avoiding penalty taxes, that might otherwise accrue.  It is crucial to recognize that each and every minutia of due process in such exchange must be completed, otherwise significant penalties can ensue.   Moreover, the IRS provisions under section 1031 only pertain to properties used for investment or business, NOT for personal use.  Also, when undertaking a 1031 Exchange, both the purchase price and the loan amount on the replacement property must be equal to or greater than the exchange property.

A 1031 exchange is of 4 basic types: Simultaneous, Delayed, Reverse or Construction/Improvement, with the most common one being a “Delayed” exchange where the original property is sold prior to the identification and purchase of a replacement property.   

USE OF A QUALIFIED 1031 INTERMEDIARY  

Department of Treasury regulations IRS clearly state who can and cannot act as a qualified intermediary or QI (the 1031 exchange facilitator).   In general, those persons who are agents of the taxpayer cannot do so; the regulations refer to those prohibited persons as a “disqualified person[s].”

“DEFINITION OF DISQUALIFIED PERSON:  (1) For purposes of this section, a disqualified person is a person described in paragraph (k)(2), (k)(3), or (k)(4) of this section. (2) The person is the agent of the taxpayer at the time of the transaction. For this purpose, a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction.”

The definition of an agent of the taxpayer in the rules makes clear that, if a professional advisor to the exchanger has provided services within two years preceding the exchange, the advisor is now a disqualified party.

The role of a QI is defined in Treas. Reg. §1.1031(k)-1(g)(4).   In most circumstances, the use of a qualified intermediary is required to successfully complete an IRS Section 1031 tax-deferred exchange. DOT Regulation §1031.1031(k)-1(g)(4)(iii) refers to the entity that facilitates a 1031 exchange as a “qualified intermediary”.

A QI or 1031 exchange qualified intermediary is also referred to as an accommodator, facilitator, intermediary, which is further clarified below:

1) A Qualified Intermediary (“QI”) is a person who:

• Is not the taxpayer or a disqualified person;

2) Enters into a written agreement with the taxpayer (the exchange agreement) under which the QI:

• Acquires the relinquished property from the taxpayer;
• Transfers the relinquished property to the buyer;
• Acquires the replacement property from the seller;
• Transfers the replacement property to the taxpayer.

3) The exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the qualified intermediary. (Per Treasury Regulations §1031.1031(k)-1(g)(4)(i))

The use of the “right” qualified intermediary can significantly reduce the headaches of an exchange by assuring the proper execution of all documentation.  Note that the QI or qualified intermediary industry is not regulated nationally. Hence, the careful selection of a qualified intermediary is essential to a smooth and penalty-free 1031 exchange transaction.

LIKE-KIND

To qualify as a 1031 exchange, the property being sold and the property being acquired must be “Like-Kind” property.  This is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset.  (For the 1031 exchange code to apply, both the relinquished property and the replacement property must be located in the U.S.)

SAME TAX PAYER

The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the “smllc” may sell the original property, and that sole member may purchase the new property in their individual name.

E.g., the single member of “Tom Thumb LLC” is Tom Thumb. The LLC can sell the property owned by the LLC, and because Tom Thumb is the sole member of the LLC, he can purchase property in his name, and be in compliance with 1031 code.  Know that in a 1031 exchange transaction it is important to stick to the formalities of each person within an ownership signing all applicable documentation.  Failure to do so will nullify the exchange.

CONSTRUCTIVE RECEIPT

A taxpayer cannot take actual possession or be in control of the net proceeds from the sale of a relinquished property in a 1031 exchange. For tax purposes, the taxpayer does not receive payment, rather those funds are held towards a replacement property to complete the exchange.  Should no replacement property emerge at the end of the 180-day exchange period or no property be identified by the end of the 45-day identification period, the funds can be received, and the sale would be reported as such. 

EARNEST MONEY PAYOUTS

Taxpayers often provide earnest money at the time the replacement property is contracted for purchase.  Prior to the closing of the replacement property purchase, typically, the taxpayer will request a reimbursement for the earnest money.   However, under 1031 exchange rules, a taxpayer cannot receive a benefit (much less a payment) from the exchange account. 

RETURN OF EXCHANGE FUNDS

Commonly, during the exchange period, a taxpayer may elect not to proceed with the transaction and request return of exchange funds.  Under 1031 regulations, QIs are only permitted to disburse funds at specific times for specific reasons.  The election by the taxpayer to terminate the account is not one of those instances. 

NOTICE TO ALL PARTIES

In a 1031 exchange, the taxpayer assigns his rights for both the sale of the old property and purchase of the new property to the qualified intermediary. Under safe harbor exchange procedures, the taxpayer must give notice in writing to ALL parties to EACH contract of the assignment of rights to the qualified intermediary. 

Interested in a 1031 Exchange? Contact one of our advisors of Triple Net Investment Group Inc to get started.