The 1031 Exchange Process in a Nutshell
| | Thursday, October 17, 2002 @ 05:00 AM EDT
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Contributed by: Larry Mayer
Larry Mayer Properties
Read more archived articles about Law and Legal Issues
Capital Gains Taxes. If you own property (real estate or personal property) for “business or investment purposes” and choose to sell it, then Uncle Sam can collect up to 20% of your profits on the sale, i.e. your federal capital gains tax. Until the time that you elect to sell your property and make a profit, you pay no capital gains taxes.
When he makes his tax claim, Uncle Sam considers only the sale of property within a very specific type, or “classification” group. Property within the same classification is considered to be “like-kind.”
Suppose you own a certain class of property -- an airplane, for example. At the moment you no longer own an airplane, he will be ready to collect from you. You can, however, periodically upgrade your aircraft for the newer and better model and still avoid capital gains taxes, provided you
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always own an airplane (i.e. the same classification of property). The same applies to farmland, rental real estate, construction equipment, etc.
Pay now or pay later. Even though you can avoid capital gains taxes while upgrading your airplane, you can’t ultimately get out of paying Uncle Sam completely. He is entitled to his tax money at the time when you cash out on that property. Yet a postponement of that payment, virtually indefinitely, can be achieved. But remember, if you want to defer those taxes, you can’t ever be without ownership of that particular class of property. For example, if you sell one piece of investment property, and one second later, buy another property (even in the same classification), then you just gave up ownership (even for one second) and Uncle Sam wants to be paid.
The Loophole. There is one way, however, to continually trade properties (within the same classification) and never be without ownership. The rule allows for you to “simultaneously” swap one property for another (i.e. an airplane for an airplane, or farmland for farmland, etc.). That kind of a swap provides for uninterrupted ownership and Uncle Sam makes no claim on taxes. But – it must be a real swap. This means that you must find a person that owns the kind of airplane you want, and that you have the kind that he wants.
Practically Speaking. Nice loophole, but the odds of finding the right person, with the right property, willing to swap at the right time are usually slim to none. In most cases, an individual will sell property to one person, then buy a replacement from another. Thus, there would appear to be an interruption in ownership, triggering the tax. Recognizing this, Uncle Sam provided yet another rule that sets out a very specific procedure, which, if precisely followed, will have the same effect as a simultaneous swap.
The Middle-man. The process is fairly simple also. You simply give all of your rights to sell, buy and hold the interim sale proceeds, to another person – the “intermediary.” The key is finding the right individual that is completely independent from your control over the matter. For example, your attorney, accountant, broker, and other persons of similar professions cannot serve as your intermediary since you are a controlling principal in those relationships. Likewise, Uncle Sam recognizes that undue influence or control can be asserted between family relatives and thus, most of them can’t be intermediaries either. All of these persons are considered to be “disqualified intermediaries.” However, every other person is “qualified” to serve as your intermediary.
The reasoning on this whole process is quite simple as well. If you never make a profit, because you never actually “received” the sale proceeds, then you can’t be taxed on it.
A “Safe Harbor” Stay close to the rules of the procedure, and you’ll be safe. Venture outside the rules and you’ll assume the tax consequences at your own peril.
Rule No. 1. Find the right qualified intermediary (“QI”). This can be a trusted friend, business acquaintance, colleague, or some other independent professional hired solely for QI purposes. Since that QI will be holding your money for you, be certain that your trust is well placed.
Rule No. 2. Be certain that the property you intend to exchange is really “like-kind” and “qualified” for a 1031 exchange. The property must be either real estate or tangible personal property. Stocks, bonds, short term leases, and other such intangible property do not qualify, even if they relate to the actual tangible property.
Rule No. 3. Enter into a written agreement with your designated QI. In so doing, the agreement will provide for several things relating to the “relinquished property” and the “replacement property,” namely: a) The QI must acquire your relinquished property from you and sell it to the intended purchaser. b) The QI must acquire the replacement property from the third-party seller and then transfer it to you. c) The sale proceeds must go into the hands of your QI and you cannot have access to any benefit of that money, either through receipt, pledging, borrowing, or other means. d) You grant the QI the authority to act as your intermediary for all intended transactions. Although it may sound confusing, all of the legal details can be wrapped up into one convenient agreement and you, as the exchangor, can “direct deed” property between yourself and the other parties just as you would in any other transaction.
Rule No. 4. Time is of the essence: Once this process has begun, you need to be very mindful of the calendar and beat the clock on every deadline. If you don’t, you lose the benefit of the whole program and Uncle Sam can collect. The clock starts on the date that you first transfer (sell) the relinquished property. From that point on, you have a limited number of days for the “Identification Period” and “Exchange Period.”
45 days (the Identification Period) is all you have to provide your QI with the “Identification” of the replacement property. If you’re not quite sure of which replacement property you will actually acquire, you can identify several properties, but: not more than 3 in total; or any number as long as the total fair market value of all of them together doesn’t exceed 200% of the fair market value of the relinquished property; or any number as long as 95% of the value of all properties identified is acquired before the end of the Exchange Period.
180 days (the Exchange Period) is the limit to take actual receipt of the replacement property (the closing date).
Trade-up or get the Boot. It’s important to understand that this property exchange process rolls the “basis” of your relinquished property into that of your replacement property. If you do not acquire a replacement property, equal or greater than the value of the relinquished property, then you run the risk of receiving “boot,” which is taxable.
Watch, but don’t touch your Money. Every effort should be made to ensure that your sale proceeds are safe and secure. Presumably, you picked a trusted individual to work with you. In some cases, a surety bond can be obtained, but is often awkward and difficult to obtain. Alternatively, escrow accounts at commercial banks are often a good bet for safekeeping, provided the account is actually an “escrow account.” The bank will likely ensure that they have a copy of the Exchange Agreement on hand to ensure compliance with the “condition” for release of the funds. Only your QI, however, should be the designated signator on the account.
Settling Up. Once your Exchange Agreement is executed and in place, there is little for the QI to do other than wait for you to make your move. The best means for requiring very little of your QI, is for you to direct deed the title to your relinquished property and have your QI ready to receive payment. (Be certain to comply with the direct deeding provisions, i.e. assignment of rights to transfer and proper notice). At or before 45 days thereafter, he will look to receive your written identification of replacement property for his file. At such time (presumably within the 180 day exchange period) another direct deeding transfer can be accomplished for the replacement property. On your instruction to the QI as to where to send the proceeds, he will then make payment on your behalf.
Not complicated enough? That’s pretty much it. I suppose I could add dozens of more pages, enumerating every conceivable nuance of this process, but it would obviously do little to enhance the understanding of this very, very simple process and the very passive role of the QI.
Note: Larry J. Mayer is the creator of The QI Guide. The QI Guide is software that can help you move property in the IRC 1031. If you plan on doing a 1031 exchange, this software is a must.
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