North American Title - 1031 Exchange

A like-kind exchange is permitted under Section 1031 of the U.S.

Internal Revenue Code if it is an arms-length transaction, meaning the seller or exchanger never has access to the proceeds from the sale. It allows an investor who holds property “for productive use in trade or business or for investment” to sell that property and purchase another like-kind property without paying capital gains taxes on any appreciation realized in the sale of the first property. Below are the critical components of a §1031 exchange.

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1. How do investors benefit from a §1031 exchange?

A §1031 exchange is a valuable tax strategy that allows investors to sell an appreciated property and acquire a like-kind property within a given time period and according to IRS rules. Instead of paying taxes on the capital gains in the neighborhood of 20-25 percent, the capital gains tax can be deferred, thus preserving the capital gains for current use. For example, if an investor purchased a small apartment building for $600,000 and sold it for $800,000, they would have to pay capital gains tax on the $200,000 profit. By immediately reinvesting those funds under the §1031 exchange rules, they preserve $40,000 – $50,000, which can be used towards the next purchase.

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2. What is a Qualified Intermediary or Facilitator?

An investor who wants to “exchange” properties must hire a qualified intermediary (QI) or facilitator to stand in their shoes to ensure that they do not have access to the funds in the interim between the sale of the first property and the purchase of the second property. On behalf of the exchanger, the facilitator relinquishes the property to the new buyer, hold the funds from the sale in escrow until the purchase of the replacement property, and transfers the newly purchased property to the exchanger.

In addition to ensuring the “safe harbor” provision of the IRS rules, an experienced QI is helpful in shepherding the transactions through what can be a very complicated process and keeps the exchanges on track. There are many companies that provide QI services. An investor who is contemplating a §1031 exchange should investigate carefully to make sure the QI is experienced and is bonded and insured.

PLEASE NOTE: A QI cannot be someone related to the exchanger, or anyone who has a financial relationship with the exchanger, such as the exchanger’s real estate agent, attorney or accountant.

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3. What is a like-kind exchange?

Although the properties exchanged are called “like-kind” it does not mean that the properties “exchanged” have to be a shopping center for a shopping center or an apartment building for another apartment building. Rather it means the properties have to be like-kind in the sense that the exchange property has to also be held “for productive use in trade or business or for investment.” This could mean exchanging a hotel for an office building, a commercial property for unimproved property, or an industrial building for a multi-family property.

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4. What are the time requirements for an exchange?

The time requirements for a §1031 exchange are very straightforward. From the day that a taxpayer sells the first property, he or she has 45 days to identify a replacement property or properties. Then the taxpayer has 180 days to close on a replacement property. During that time, the QI is holding the funds realized from the first sale in escrow, in a segregated account, to be used when the replacement property is purchased.

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5. What special information is required in the case of a §1031 exchange?

The QI will need ample information about the property that is being sold, for instance when it was acquired, how much the taxpayer paid for it, what was the use of the property and how it was vested. They will also need to know what the taxpayer is interested in acquiring for the replacement property or properties.

For purposes of closing the two transactions, the Escrow Officer will need the QI’s contact information, since the sale and purchase will go through the QI, and will need to know how the new property will be vested.

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6. How is the Closing and Escrow handled in a §1031 exchange?

The closing and escrow are handled in traditional fashion by an Escrow or Closing Agent. However, since the QI is standing in the shoes of the seller, in the case of a relinquished property, or in the shoes of the buyer, in the case of a replacement property, all paperwork and funds must go through the QI.

The Escrow Agent will send the purchase agreement, title commitment and closing costs to the QI as the substitute buyer or seller. The exchanger – the buyer or seller – acknowledges all preliminary and final closing statements, but ultimately, they must be signed by the QI. Since the exchanger never touches the funds, the funds will be wired to or from the QI as well. Any excess funds will go back to the QI and then subsequently returned to the exchanger.

While the QI handles the funds, the deed itself is directly deeded from the buyer to the seller in both cases to avoid duplicate transfer and conveyance fees.

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7. Cautionary Note

As with all complicated real estate transactions, real estate agents should urge their buyers and sellers to seek out attorneys and certified public accountants who have expertise in these areas. This will ensure they are receiving the best guidance possible before entering into the exchange process.

This information is provided as a general educational resource and is not intended to, and shall not be deemed to, constitute legal advice. For questions concerning a specific situation, please contact an attorney or tax professional.

Contact a North American Title agent today to learn how our expert Closing and Escrow Agents can safely handle your next §1031 exchange.

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