Understanding 1031 Tax Deferred Exchanges | ||
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In a typical Forward Delayed Exchange, the most common type of exchange, the taxpayer sells business or investment property and acquires Replacement Property of equal or greater value within 180 days. The use of a Qualified Intermediary is a safe harbor requirement to facilitate a valid tax deferred exchange. This Qualified Intermediary must possess intimate knowledge and a thorough understanding of 1031 regulations.
Skilled Guidance Through 1031
Before you begin the exchange process, be sure to consult with your tax or financial advisor to ensure that a 1031 exchange is right for you.
Step One: Sale of the Relinquished Property
Before the sale of the first property the Exchanger must complete the documentation prepared by the Exchanger. At closing, the proceeds are delivered directly to the Exchanger, as the Qualified Intermediary
Step Two: Identification of the Replacement Property
The Exchanger must identify the property to be purchased (generally called the "Replacement Property") within 45 days following the sale of the Relinquished Property. The taxpayer may generally identify three properties as a potential Replacement Property, or more under alternate rules of identification.
Step Three: Purchase of the Replacement Property
The Exchanger must obtain the Replacement Property within 180 days following the sale of the Relinquished Property, which must be identified property, subject to the rules listed above. At closing, the proceeds are paid directly by the Exchanger, as the Qualified Intermediary, and the Exchanger receives the Deed to the Replacement Property.
Key Rules of a Successful Exchange
For a successful exchange, strict adherence to Section 1031 is imperative. As an investor, it is important that you understand the following rules.
Investment Intent
Both the property sold (Relinquished Property) and the property purchased (Replacement Property) must be held for investment or productive use in a trade or business. None of the properties exchanged can be your personal residence.
Time Frames
Replacement Property(ies) must be identified within 45 days of the sale of the Relinquished Property and must be purchased within 180 days of the sale of the Relinquished Property.
Identification
You can identify up to three Replacement Properties of any value during the Identification Period, or more, subject to certain conditions.
Like-Kind
The Replacement Property must be "Like-Kind" to the Relinquished Property. Any type of real property is Like-Kind to other real property. For example, a shopping center is like-kind to an investment condominium and a warehouse is like-kind to raw land.
Common Ownership
The party selling the Relinquished Property must be the same party purchasing the Replacement Property or a disregarded entity with respect to that party.
Property Value
You must purchase a property of equal or greater value to the property sold or pay tax on the difference.
Exchange Values
You must use all of the cash proceeds from the sale of your Relinquished Property toward the purchase of Replacement Property or pay tax on the difference. If you offer seller financing on your Relinquished Property you may be subject to tax as the principal is repaid.
Qualified Intermediary
To qualify for safe harbor tax deferral, sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the purchase of the Replacement Property.
Types of Exchanges:
Simultaneous Exchange
A Simultaneous Exchange occurs when two properties are exchanged simultaneously. This can happen when two properties are swapped, property for property, which is called a two-party exchange. This can also happen when a property is sold and the replacement property is purchased simultaneously. To ensure safe harbor protection, a Qualified Intermediary should facilitate the exchange.
Forward Delayed Exchange
The most common type of exchange, the Forward Delayed Exchange, happens when a property is sold (Relinquished Property) and another property is purchased (Replacement Property) within 180 days following the sale of the Relinquished Property. For a safe harbor Forward Delayed Exchange, the sale proceeds must be held by a Qualified Intermediary between the sale of the Relinquished Property and the subsequent purchase of the Replacement Property.
Construction Exchange
Construction Exchanges, or Build-to-Suit Exchanges, occur when the taxpayer uses the funds from the sale of the Relinquished Property to construct improvements on the Replacement Property. The property on which the improvements are constructed cannot be held by the taxpayer but must be held by a third party called an Exchange Accommodation Title Holder until either the improvements are complete or until the end of the 180 Exchange Period, after which the title holder is deeded the Replacement Property with the improvements. Due to its complexity, a Construction Exchange incurs higher fees.
Reverse Exchange
In a Reverse Exchange, the Replacement Property is purchased before the sale of the Relinquished Property. The Replacement Property must be held by an Exchange Accommodation Title Holder until the sale of the Relinquished Property, which must take place within 180 days following the purchase of the Replacement Property. Due to its complexity, a Reverse Exchange incurs higher fees.
