Overview of 1031 Tax Deferred Exchange
1031 Tax Deferred Exchange
A 1031 Tax-Deferred Exchange is a transaction that allows character owners to preserve the complete value of their investment character. A 1031 Exchange allows owners who decide to dispose of their investment similarities, to do so and avoid having to pay capital gains taxes by allowing them to reinvest their sales proceeds for “like kind” similarities.
The general rules governing a 1031 Exchange are fairly simple. Any kind of character (real or personal) can be exchanged provided the relinquished character was before held for investment purposes. Under most circumstances, a personal residence will not qualify as a tax-deferred exchange.
- LIKE KIND The substitute character must be of “like kind” to the relinquished character. “Like kind” does not average exactly the same. Most any real character is considered “like kind” to other real character such as the exchange of a single-family rental home for a condominium, warehouse or office building.
- character VALUE As a rule of thumb, the character you acquire must have both value and equity equal to, or greater than the character relinquished.
- IDENTIFICATION PERIOD – The character to be acquired must be identified within 45 days of the closing of the relinquished character. character identification rules include:
- Three (3) character RULE: Up to three (3) similarities may be identified, no matter what their value,
- OR 200 PERCENT RULE: Any number of similarities may be identified, as long as their combined fair market value isn’t more than twice that of the relinquished character
- OR 95 PERCENT RULE: Any number of similarities may be identified, in spite of of their combined fair market value, as long as you acquire 95% of that total value.
- EXCHANGE PERIOD – The acquisition of the new character must be completed within 180 days of the move of the relinquished character, or by the filing date of the tax return for the year the first character was transferred, whichever comes first. These time restrictions must be strictly followed for the exchange to be allowed by the IRS. The IRS does not grant extensions.
- STEPS INVOLVED IN A SUCCESSFUL EXCHANGE
- buy Contract. A contract is executed between the Buyer and Seller for the buy and sale of the relinquished character. The buy contract should contain a “cooperation clause” in which the Buyer agrees to cooperate with Seller in structuring and completing a 1031 exchange. The Seller (or Buyer) will assign their interest in the agreement to a Facilitator or a Qualified Intermediary (FAC or QI).
- Exchange opened. The exchange is set up with the FAC or QI usually after escrow has been opened for closing the sale. The necessary documentation to affect the exchange should then be prepared. The Exchange Agreement (between the taxpayer and the FAC or QI) defines the exchange transaction and sets forth the obligations of both the taxpayer and FAC or QI. An Assignment of the relinquished character buy contract to FAC or QI is prepared, assigning the rights as Seller to the FAC or QI.
- Closing the relinquished character. The relinquished character closes when all conditions of sale have been met and the character is conveyed to the Buyer. While the conveyance will be directly from Seller to the Buyer, it will represent a move from the Seller to the FAC or QI in exchange for other character to be received at a later date. The proceeds from the sale are delivered directly to the FAC or QI for the substitute character. At no time should the Seller be in either actual or constructive receipt of the cash proceeds.
- Identification of substitute character. The time period to clarify the character (or similarities) to be purchased as the substitute character starts on the closing of the relinquished character. Forty-five (45) days from the date of move is allowed to clarify the acquisition character.
- buy Contract for substitute character. After the identification of a appropriate “like kind” substitute character and a decision as to which character will be acquired, a buy contract will be entered with the Seller. The character must be one or more of the similarities identified by the end of the 45 day identification period.
- Exchange documentation for the acquisition character. The Assignment of the buy contract for the substitute character and the Release and Warranty to be executed by the Buyer and Seller should then be prepared. Instructions should also be prepared for the settlement agent noting the necessary items to complete the exchange.
- Closing the substitute character. When the conditions of closing have been met, the FAC or QI should deliver the funds it has been holding to the settlement agent to acquire the substitute character. The Seller will convey the substitute character directly to the Buyer. The closing of the substitute character must occur within 180 days of the move of the relinquished character (or by the tax return due date, if earlier) in order for the transaction to qualify for Section 1031 treatment.