The opportunity to protect hard earned equity in the sale of an investment has been available to consumers since 1921. However, Complexities and details of the tax code prevented only the most knowledgeable from using this option. In 1990 the Omnibus Budget Act clarified the process and opened this option to a broader set of consumers.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.
The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as a part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
THE FACILITATOR OR QI
Your seller must hire a qualified intermediary (QI) or facilitator to stand in their shoes to
1) Relinquish the property they are selling to the new buyer.
2) Hold the funds from the sale in escrow until the purchase of the replacement property.
3) Transfer the newly purchased property to your client. The QI cannot be someone related to the exchanger, or anyone who has a financial relationship with the exchanger, such as their real estate agent, attorney or accountant
Although the properties exchanged are called “like-kind” it does not mean that the properties “exchanged” have to be a shop-ping center for a shopping center, but rather that the new property also has to be held “for productive use in trade or business or for investment.” This could mean exchanging a hotel for an office building, a commercial property for unimproved property, or an industrial building for a multi-family property.
TIMING IS EVERYTHING
The time requirements for a §1031 exchange are very straightforward. From the day that your client sells the rst property, he or she has 45 days to identify a replacement property or properties. Then your client has 180 days to close on a replacement property. During that time, the QI holds the funds realized from the rst sale in escrow, in a segregated account, to be used when the replacement property is purchased.
THE CLOSING OF ESCROW
The closing is handled in traditional fashion by an Escrow or Closing Agent. However, the QI stands in the shoes of a seller, in the case of a relinquished property, or in the shoes of the buyer, in the case of a replacement property. Your client will acknowledge all preliminary and final closing statements, but ultimately, they must be signed by the QI. Since your client never touches the funds, the funds will be wired to or from the QI as well.
This information is provided as a general educational resource and is not intended to, and shall not be deemed to, constitute legal advice. For questions concerning a specific situation, please contact an attorney or tax professional.