(As published by Land Title)
What is a Tax Deferred Exchange?
A tax deferred exchange is one of the few tax shelters remaining. Its use permits a taxpayer to relinquish certain investment property and replace it with other “like-kind” investment property without triggering capital gains liability. Thus, the owner has additional capital available for the purchase of the “replacement” property, which otherwise would have been paid in taxes. Payment of the tax on the gain is deferred until the final “replacement” property is sold.
What is a Delayed Exchange?
The Treasury Regulation of 1991 acknowledged the ability to do a “delayed” exchange as opposed to one done simultaneously. A number of requirements are imposed including specific time periods for completion of the exchange. The taxpayer must identify the replacement property within 45 days and close the purchase of the replacement property within 180 days (or the date of filing tax return if earlier) of the closing of the relinquished property. Also the taxpayer cannot receive any proceeds from the sale of the relinquished property, actually or constructively. Thus, if the replacement property is to be purchased subsequent to the sale of the relinquished property, all money must be held by a “Qualified Intermediary”.
What is the Advantage of a 1031 Exchange?
The primary advantage to performing a 1031 Exchange is that through the deferment of capital gains taxes, the “Exchangor” is able to acquire more valuable and more leveraged investment property. If it is the intent of the taxpayer to reinvest the proceeds from one property into another, the 1031 Exchange remains the only vehicle remaining for full tax deferment.
The disadvantage is, of course, that fund must remain invested. There is also the additional cost of the transaction, which is the exchange fee.
How does the 1031 Exchange benefit the Realtor?
The availability of the 1031 Exchange has the potential to increase the Realtor’s business. Often the Listing Agent on the relinquished property is able to act as the Selling Agent on the purchase of the replacement property. The increase in commissions is one benefit and the Realtor’s knowledge and versatility has been expanded which undoubtedly leads to increased referrals.
Who may act as a Qualified Intermediary?
The Regulations list those parties who may not be qualified to act as an intermediary. If the person is the agent of the Exchangor at the time of the transaction, he is disqualified. This includes any person who has acted as the Exchangor’s employee, attorney, accountant, investment banker, or broker, or real estate agent or broker within the two year period prior to the date of transfer of the relinquished property, as well as relatives and controlled corporations. Consequently, the role of the Qualified Intermediary has generally been filled by title insurance, escrow or trust companies.
Issues to consider when choosing a Qualified Intermediary
Are they already disqualified?
What are the chances of bankruptcy?
In case of misappropriation of funds, do they have a surety bond?
In case of death or injury, is there a backup?
How in depth is their exchange agreement?
How are the funds deposited?
How quickly can the funds be released?
What is the fee structure? Beware of hidden fees.
Do they pay interest on the proceeds being held?
Are they a member of the FEA )Federation of Exchange Accommodators)? For more information visit www.1031.org
What is the qualification of “like-kind” property?
It is important when identifying a replacement property to choose “like-kind” property. “Like-kind” refers to the intended purpose of the property rather than the exact description of the property. Certainly all 1031 Exchanges are real property held for investment purposes, trade, or business, so the exchange of a rental house for a retail center, for example, is acceptable.
The tax code specifically lists properties that are not considered “like-kind”. Theses including 1) stock in trade or other property held primarily for sale; 2) stocks, bonds, or notes; 3) other securities or evidences of indebtedness; 4) interests in a partnership; 5) certificates of trust or beneficial interest. Also the property must be in the United States.
Ten considerations when completing a 1031 Exchange
1.The taxpayer/Exchangor is advised to consult with his or her CPA or Tax Attorney.
2.The Exchange Addendum should be added to the Contract to Buy or Sell Real Estate.
3.Qualified Intermediary (QI) should be notified.
4.When the title work is ordered, add the QI to delivery.
5.Establish the Exchange Agreement with the QI
6.Inform the QI of the closer or contact with the title company.
7.Attend the closing and make sure that the proceeds go directly to the QI.
8.Send your list of Identified Replacement Property(ies) to the QI by the 45 days deadline.
9.Send the Assignment of Contract Replacement Property to the QI prior to closing the Replacement Property.
10.Make sure that the QI has transferred the proceeds to the closer of the Replacement Property and that there is no cash back to the buyer.