By Robert Steeg
Many property owners are generally familiar with the idea of deferring the taxable gain on the sale of real estate by applying the proceeds of the sale to the purchase of another parcel of like-kind property under Section 1031 of the Internal Revenue Code—a so-called “Section 1031 exchange.”
Steeg Law has helped many clients utilize this important provision of the tax code. There are a couple of ways to accomplish a Section 1031 exchange:
- The traditional method, by which the property owner/taxpayer first sells his or her property (called the “relinquished property”) and then later uses the proceeds of that sale to buy the next property (called the “replacement property”).
- The “reverse” Section 1031 exchange, which is a bit more complicated because it involves buying the “replacement property” first and subsequently selling the “relinquished property.”
Section 1031 Rules – It’s Complicated
There are very detailed rules that must be followed in order to obtain the tax advantages under Section 1031. Strict compliance with those rules is required. For example, a “tax intermediary” must be employed so that the funds from the sale of the relinquished property never actually become the property of the taxpayer, but are instead held by the tax intermediary and applied to the purchase of the replacement property. In a “reverse” Section 1031 exchange, the tax intermediary actually takes title to the replacement property, and then later receives the proceeds from the subsequent sale of the relinquished property as the “consideration” for its transfer of the replacement property to the taxpayer.
In the traditional Section 1031 exchange, the replacement property must be identified by the taxpayer on a list of possible replacement properties within 45 days after the date of the sale of the relinquished property, and the actual purchase of the replacement property must take place within 180 days of the date of the sale of the relinquished property. Similarly, in a “reverse” Section 1031 exchange, the taxpayer must identify the relinquished property within 45 days, and close the sale of the relinquished property within 180 days, of the date of the taxpayer’s prior purchase of the replacement property. (There are some circumstances under which these deadlines might be adjusted, but these deadlines represent the bright-line, safe-harbor tests that assure compliance.)
Section 1031 – How to Preserve Your Tax-deferral Benefits
Below is an article from a tax intermediary company with whom we frequently work, First American Exchange Company (504-539-5933), highlighting the complexity of the process and pointing out important areas where the property owner/taxpayer must be extremely careful, in order to preserve the tax-deferral benefits of a Section 1031 exchange.
Five Ways to Ruin Your 1031 Exchange
Some people are surprised at how many grey areas there are when structuring an exchange. There are some important rules, which are generally clear, however it’s important to pay attention because a mistake can ruin your exchange. Here’s what not to do:
1. Miss the 45-Day Identification Deadline
Once you close on your relinquished property, you have 45 days to identify in writing what you intend to acquire in the exchange. The only exception to this rule is that no identification is needed if you acquire the replacement property before the end of the 45-day period.
The rule states that property that is not identified will not be “like kind” to the relinquished property; therefore, you are only able to acquire replacement property that you identified. If you do not identify or acquire the replacement property within the 45 days, you are not able to complete a valid exchange.
2. Fail to Clearly Identify What You Are Going to Buy
In addition to making sure you identify replacement property within 45 days, you must identify it unambiguously. That generally means using a legal description or street address. If you are going to acquire a tenancy-in-common interest in the property, you should try to identify as closely as possible the percentage interest you will be acquiring. If you are acquiring a condominium, you need to also identify the unit number. Moreover, if improvements will be constructed on the replacement property between the date you identify it and the date you acquire it, you must identify what will be constructed on the property in addition to the legal description or address. You should provide as much detail about the improvements as is “practicable.”
3. Miss the 180-Day Deadline
Another crucial deadline is the 180-day exchange period. This rule states that you must acquire (close, or transfer) all replacement property(ies) by the 180th day. If the relinquished property closes escrow towards end of a tax year such that the 180th day falls after your tax filing date of the following year, you’ll need to complete your 1031 Exchange before filing your income tax return, or request an extension. The Exchange timelines begin from the date the relinquished property closes escrow, and includes weekends and holidays. Should your 180th day fall on Saturday or Sunday, the last day to acquire the replacement property(ies) will fall on the previous business day. For purposes of both the 45-day and 180-day periods, if there are two or more relinquished properties in the same exchange, the deadlines are measured from the date of the first relinquished property closing.
4. Close Before You Sign Exchange Documents
Initially, exchanges could only be accomplished by two people simultaneously swapping properties. Eventually, the deferred exchange rules permitted taxpayers to use a qualified intermediary, such as First American Exchange Company, to act as an accommodator. The rules convert what looks like a sale followed by a purchase into an exchange. A basic requirement of this process is that an Exchange Agreement and Assignment Agreement must be signed by the taxpayer before the date the relinquished property closes escrow. In addition, the taxpayer must notify the buyer the contract has been assigned to a qualified Intermediary. The qualified intermediary will also be assigned into the replacement property contract, thus allowing the funds to be transferred within the “safe harbors”
5. Take Possession of Your Exchange Funds
Another important rule for a successful 1031 Exchange states that the taxpayer cannot have possession, or control, of the proceeds from the sale of the relinquished property. Upon closing of the relinquished property, the escrow holder will transfer the funds directly to First American Exchange Company, thus keeping the taxpayer from having receipt of the funds. One of the reasons it is so important to choose an intermediary wisely is that they hold the proceeds of your sale until you are ready to acquire the replacement property. First American holds these funds only in FDIC-insured bank accounts, and we never invest them in securities. Furthermore, funds are invested in a segregated account specific to the taxpayer’s tax ID number.