Introduction to 1031 Exchanges

What is an IRC 1031 Tax Deferred Exchange?

Simply put, an IRC 1031 tax deferred exchange allows owners of real or personal property to defer the recognition of a capital gains tax when they have sold their property.

They have been around in one form or another since 1921 and in its current form since 1986.

An exchange is structured just like any other sale or any other purchase, but with the inclusion of a qualified intermediary to structure the transaction as an exchange. It is very important to involve the qualified intermediary before you start your transaction.

Exchanging allows you to reinvest money into a new business or an investment property that you otherwise would have had to pay in taxes to the government.

If you prefer a video on 1031 Exchanges, please look at this one from the REI Club. Below the video is additional important information about the 1031 Exchange.

What types of properties may be exchanged?

Exchanges can involve real property or personal property. Property to be exchanged must be held for business or investment purposes and not primarily for resale purposes or personal use.

The properties that are exchanged must be “like kind” to each other. Concerning real estate exchanges, the properties do not have to be the same type. As long as they are both held for business or investment purposes they are considered like kind. Personal property like kind rules are generally more restrictive.

As an exchanger you have the opportunity to purchase replacement property of any type. As an example, you can sell vacant land and purchase a strip mall; or sell an apartment building and buy an industrial complex. Although 1031 exchanges are governed by federal law, it is state law that determines what is and what is not real property. Exchanges of real estate interests such as air rights, easements, timber, conservation easements and development rights may be possible. Thus, all property held for business or investment purposes is like kind to all other property held for business or investment purposes.

How long do I have to identify property?

When completing an exchange, an exchanger has 45 days from the date of the sale of the first relinquished property to identify potential replacement property or properties; and a total of 180 days from the original sale date to purchase the replacement property or properties.

Identification rules make it easy for exchangers to pick multiple properties that they might purchase, but the fact is that once the 45 days are up, the exchanger’s choices on that list are set in stone. The identification is a written letter or form which is signed and dated by the taxpayer, and contains an unambiguous description of the property. A property which is identified is not required to be under contract or in escrow to qualify. Exchangers acquiring an undivided percentage interest (“fractional interest”) in a property should identify the specific percentage that will be acquired.

However, there are restrictions on the number or value of the properties an exchanger can identify. To qualify for the exchange, the exchanger must comply with the following identification options:

1)  The Three Property Rule; The three property rule allows an exchanger to identify up to three replacement properties. There is no value limitation placed upon the prospective replacement properties and the exchanger can acquire one or more of the three properties as part of the exchange transaction. The three property rule is the most commonly used identification option, allowing an exchanger to identify fall back properties in the event the preferred replacement property cannot be acquired.
2)  The 200% Rule; The exchanger can identify an unlimited number of properties, provided that the total value of the properties identified does not exceed 200% of the value of all relinquished properties. There is no limitation on the total number of potential replacement properties identified under this rule, only a limitation on the total fair market value of the identified properties. In other words, if an exchanger sold relinquished property for $1,000,000 under the 200% rule, the exchanger would be able to identify as many replacement properties as desired, provided the aggregate fair market value of all of the identified properties does not exceed $2,000,000 (200% of the $1,000,000 sales price of the relinquished property).
3)  The 95% Exception Rule; The exchanger may identify an unlimited number of replacement properties exceeding the 200% fair market value rule, however the exchanger must acquire at least 95% of the fair market value of the properties identified. This rule is utilized in limited circumstances as there is a much higher risk of the transaction failing. In other words, assume an exchanger identifies ten properties of equal value. In order to satisfy the rule, the exchanger would be required to acquire all ten identified properties within the exchange period to complete a successful exchange. If one of the properties fell through, the entire 1031 exchange would be disqualified because the exchanger did not acquire 95% of the fair market value identified. This rule should only be utilized in situations where there is a high level of certainty pertaining to the acquisition of the identified properties and the other two rules do not meet the exchanger’s objectives.

In addition, to obtain a complete deferral of the capital gains tax, the taxpayer must acquire replacement property of equal or greater value, obtain equal or greater debt on the replacement property, reinvest all the net proceeds realized from the sale of the relinquished property and acquire only like-kind property.

What is the structure of a delayed exchange?

In the case of a simultaneous or delayed exchange, the exchanger first enters into a contract to sell the relinquished property or properties. Contrary to popular belief, there is no “exchange contract” for a delayed exchange. The exchanger enters into a contract that they would normally use if they were not structuring the transaction as an exchange. However, the addition of an exchange cooperation clause is recommended to secure the cooperation of the buyer or seller of the relinquished property or replacement property. A person or entity that is not a disqualified party, usually a Qualified Intermediary, thereafter assigns into the rights, but not the obligations of the contract. This assignment creates the legal fiction that the Qualified Intermediary is actually swapping one property for another. In reality, the exchanger sells the relinquished property and purchases the replacement property from whomever he wishes in an arms length transaction.

In addition to the assignment of contract, there must be an exchange agreement entered into prior to the closing of the first property to be exchanged. The exchange agreement sets forth the rights and responsibilities of the exchanger and the entity acting as a qualified intermediary, and classifies the transaction as an exchange rather than a sale and subsequent purchase. In addition, the exchange agreement must limit the exchanger’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period. In other words, the exchanger may only use the exchange funds to purchase new property and to pay most of the expenses related to the sale and purchase of the properties.

Once the exchange agreement and assignment of contract are executed, the exchanger sells the property; however instead of collecting the proceeds at the closing, they are sent directly to the Qualified Intermediary. When the replacement property or properties are located, the exchanger enters into a contract to purchase same, and thereafter uses the exchange funds to complete the purchase. This, in a very basic form, is the structure of a delayed tax deferred exchange.

What should I look for in a Qualified Intermediary?

When choosing a Qualified Intermediary it is important to look for the following items:

1)  What is the experience of the person who you are speaking with? How long have they been in the industry? Are they a tax or legal professional such as an attorney or CPA? Remember, the person on the other end of the phone may be from a big company but they may only have a few months experience. It is important to ask.
2)  Does the Qualified Intermediary segregate the exchange funds into separate Qualified Escrow Accounts as provided in the Treasury Regulations or do they co-mingle the exchange funds? A Qualified Intermediary that uses internal “memorandum accounts” is not providing you with the maximum protection that the Safe Harbors of the Treasury Regulations allow.
3)  Have you received a copy of the Fidelity Bond and Errors and Omissions coverage before you have started your exchange? Is the amount of coverage for each transaction greater than the cash proceeds that you will be sending? Have you verified the Fidelity Bond and Errors and Omissions coverage are in full force and effect? Does the Fidelity Bond provide for principal liability? Many fidelity bonds only provide protection from employee malfeasance but leave the exchanger uninsured in the case of malfeasance of a principal.

It goes without saying that service is an extremely important part of an IRC 1031 tax deferred exchange and that exchanges are subject to strict guidelines and requirements. Having a financially strong, experienced and capable Qualified Intermediary is an important step in getting you through the tax deferred exchange process.

As I say throughout my blogs, if I may be of assistance with your real estate questions please contact me, I truly want to help. My way of giving back is to give away my knowledge. Thank you for reviewing this blog.