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The Process of a 1031 Tax-Deferred Exchange Explained

May 12, 2022, 8:45 AM

When selling real estate, sellers can face significant tax obligations from the profit of the property sold.

However, by using the process of a 1031 tax-deferred exchange, a property seller can shift their funds from the sold property to a new purchase or purchases without an obligation to pay capital gains taxes. The process, guided by a qualified intermediary or a certified specialist for tax-deferred exchanges, can help property owners build net worth much faster than normal.

How Does a 1031 Tax-Deferred Exchange Work?

According to Treas. Reg. 1.1031(k)-1, a person owning real estate for investment or business purposes can sell their property and then purchase “like kind” property to defer paying their capital gains tax with the support of a qualified intermediary. The desired replacement property must be identified by the property owner, known as an exchanger at this point in the process, within 45 days. The new property must also be settled within 180 days of the date of settlement of the relinquished property.

How Does a Qualified Intermediary Facilitate a 1031 Tax-Deferred Exchange?

The qualified intermediary, often referred to as a QI, has numerous responsibilities. Initially, the QI drafts the exchange agreement and assignment documents, documents that allow one party to transfer the rights and benefits of a contract to another party. The QI then accepts the assignments of all contracts associated with the exchange and notifies all parties of these assignments. From there, the QI provides instructions to the settlement agent, a professional who facilitates the transfer of real property in a purchase and sale. The QI also creates a qualified escrow account for the proceeds from the sale, eventually funding the settlement of the replacement property from the escrow account. The QI receives the required 45-day identification notice for the replacement property and handles the direct deeding issues. Finally, the QI prepares a comprehensive accounting of the funds placed in escrow and copies of all exchange and closing documents.

What Are the Distinctions for “Like Kind” Property?

To qualify for a 1031 tax-deferred exchange, the exchanger needs to find a property considered “like kind.” This doesn’t refer to the grade or quality of a property but rather the property’s nature or character. For example, if you own a single-family rental property and wish to purchase a farm as a replacement, that falls under the definition of “like kind.” Exchanging a lot or condominium for an office building also meets those guidelines. The IRS has broadly defined that any kind of real estate may be exchanged for any other kind of real estate.

When Conducting a Tax-Deferred Exchange, What Are the Requirements for Reinvesting in a Replacement Property?

The replacement property must be of equal or greater value than the relinquished property and all cash equity from the sale must be reinvested to have no tax on the sale of the relinquished property. If the exchanger buys a property of lesser value, the difference of the two property values is subject to capital gains tax and unrecaptured depreciation tax.

What Properties Don’t Meet 1031 Requirements?

A personal primary residence doesn’t fall under the guidelines for a 1031 exchange. Spec houses or properties designated for a quick turnaround—i.e., purchasing a home and completing quick improvements for immediate sale—are also not eligible.

Step-by-Step Events of a 1031 Tax-Deferred Exchange

  1. The property to be relinquished goes under contract.
  2. The property owner secures a qualified intermediary and enters into an exchange agreement.
  3. The qualified intermediary is assigned the sales contract.
  4. The property sale is completed, and the qualified intermediary places the proceeds in a short-term escrow account.
  5. The property owner conveys the title of the relinquished property to the buyer.
  6. Within 45 days, the property owner identifies up to three replacement properties and informs the qualified intermediary of their choice. In addition to the 45-day contingency, the property must be located in the US and be settled within 180 days.
  7. The property owner enters into a contract to purchase the replacement property.
  8. The sales contract for the new property is then assigned to the qualified intermediary.
  9. Closing on the replacement property occurs within 180 days.
  10. The qualified intermediary transfers the proceeds from the short-term escrow account to the replacement property seller through the closing attorney or title company, with the exchanger receiving any remaining funds, provided there are any, from the account.
  11. The title is conveyed to the property owner from the seller of the replacement property.

Despite stringent guidelines and restrictions on tax-deferred exchanges, investment and business property owners can benefit greatly from utilizing this type of transaction. If you’re planning on selling an investment or business property, investigate the options available to you to save thousands of dollars in taxes.

The assistance of a qualified intermediary is key in completing a tax-deferred exchange. They provide a deep working knowledge of the exchange procedures and years of experience that can make the process much easier. IRC Section 1031 forbids parties such as the seller’s agent, broker, attorney, accountant, family members, and business partners from acting in this capacity.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Randy Kaston is the director of Business Law Group at Ligris + Associates. Kaston concentrates on all aspects of commercial and residential transactions, including representing lenders in closing complex commercial, asset-based, real estate, construction, and SBA loans, as well as business lines of credit.

John Starling is the Senior Vice President of Northern Bank’s 1031 Exchange, LLC. Starling helps both people and business entities preserve profit and build wealth faster through tax-deferred exchange.

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