Deferred 1031 Exchange

1031 Tax-Deferred Exchanges

If you are selling investment or business property, the choice is yours: you can give your money away, or you can defer your capital gains taxes with a simple 1031 exchange.

Internal Revenue Code Section 1031 is a powerful tool for deferring capital gains tax on commercial/investment transactions. It allows taxpayers to exchange real or personal property for new "like-kind" property, while deferring recognition of any capital gains

In order to accomplish a tax-free "exchange" there must be an exchange of properties. That doesn't mean, though, that you sit down with another property owner and just trade deeds. It would be virtually impossible to find another person with investment property of identical value who wants to make a swap. In 1984, Congress enacted legislation to allow deferred exchanges, meaning that an investor could sell property to an unrelated buyer, after having entered into an exchange agreement with a qualified intermediary, and then identify any like kind property within certain timeframes. The legislation spawned a number of creative methods of accomplishing an exchange, providing many tools for the creative tax planner.

A taxpayer desiring to do a 1031 Exchange lists and/or markets his property for sale in the normal manner without regard to the contemplated 1031 Exchange. A buyer is found and a contract to sell the property is executed. Accommodation language is usually placed in the contract securing the cooperation of the buyer to the seller's intended 1031 Exchange, but such accommodation language is not mandatory.

When contingencies are satisfied and the contract is scheduled for a closing, the services of an Intermediary are arranged for. The taxpayer enters into an Exchange Agreement with the Intermediary, which permits the Intermediary to become the "substitute seller" in accordance with the requirements of the Code and Regulations.

The Exchange Agreement usually provides for:

• An assignment of the seller's Contract to Buy and Sell Real Estate to the Intermediary.
  
• A closing where the Intermediary receives the proceeds due the seller at closing. Direct deeding is used. The Exchange Agreement will comply with the requirements of the Code and Regulations wherein the taxpayer can have no rights to the funds being held by the Intermediary until the exchange is completed or the Exchange Agreements terminates. The taxpayer "cannot touch" the funds.
  
• An interval of time where the seller proceeds to locate suitable replacement property and enter into a contract to purchase the property. The interval of time is subject to the 45-Day and 180-Day rules.
  
• An assignment of the contract to purchase replacement property to the Intermediary.
  
• A closing where the Intermediary uses the exchange funds in his possession and direct deeding to acquire the replacement property for the seller.

The first timing restriction for a delayed Section 1031 exchange is for  the taxpayer to either close on Replacement Property or to identify the  potential Replacement Property within 45 days from the date of transfer  of the exchanged property. The 45-Day Rule is satisfied if replacement  property is received before 45 days has expired. Otherwise, the  identification must be by written document (the identification notice)  signed by the taxpayer and hand-delivered, mailed, faxed, or otherwise  sent to the Intermediary. The identification notice must contain an  unambiguous description of the replacement property. This includes, in  the case of real property, the legal description, street address or a distinguishable name.

After 45 days, limitations are imposed on  the number of potential Replacement Properties, which can be received as  Replacement Properties. More than one potential replacement property  can be identified under one of the following three conditions:

The Three-Property Rule - Any three properties regardless of their market values.

The 200% Rule  - Any number of properties as long as the aggregate fair market value  of the replacement properties does not exceed 200% of the aggregate FMV  of all of the exchanged properties as of the initial transfer date.

The 95% Rule  - Any number of replacement properties if the fair market value of the  properties actually received by the end of the exchange period is at  least 95% of the aggregate FMV of all the potential replacement  properties identified. 

Although the Regulations only require written notification within 45  days, it is recommended practice for a solid contract to be in place by  the end of the 45-day period. Otherwise, a taxpayer may find himself  unable to close on any of the properties which are identified under the  45-day letter. After 45 days have expired, it is not possible to close  on any other property, which was not identified in the 45-day letter.  Failure to submit the 45-Day Letter causes the Exchange Agreement to  terminate and the Intermediary will disburse all unused funds in his  possession to the taxpayer. 

The replacement property must be received and Exchange completed no  later than the earlier of 180 days after the transfer of the exchanged  property or the due date (with extensions) of the income tax return for  the tax year in which the exchanged property was transferred. The  replacement property received must be substantially the same as the  property, which was identified under the 45-day rule described above.  There is no provision for extension of the 180 days for any circumstance  or hardship.

As noted above, the 180-Day Rule is shortened to  the due date of a tax return if the tax return is not put on extension.  For instance, if an Exchange commences late in the tax year, the 180  days can be later than the April 15 filing date of the return. If the  Exchange is not complete by the time for filing the return, the return  must be put on extension. Failure to put the return on extension can  cause the replacement period for the Exchange to end on the due date of  the return. This can be a trap for the unwary.