An Introduction to 1031 Tax-Deferred Exchanges
By Jim Camp, CCIM, Associate Broker
Welcome to the first of a series of 9 blogs centering around the real estate strategy of 1031 Tax-Deferred Exchanges – what they are, how they work, rules and regulations, benefits, and other issues. This is not meant to be a complete guide to all the aspects of the strategy, but rather an introduction allowing someone unfamiliar with 1031 Tax-Deferred Exchanges to gain an insight of how it may or may not be right for you as a real estate investor.
Today’s blog will cover 3 topics – What to know, what it is, and what is a Qualified Intermediary.
The concept of the Tax-Deferred Exchange comes out of the Internal Revenue Code Section 1031. It is a strategy to defer capital gains tax by selling “like-kind properties” and using the proceeds from the sale of an investment property to purchase another property or properties. The newly acquired property must be of equal or greater value than that which was relinquished. A successful transaction can free up cash, known as “boot”. If the Seller opts to take this cash out of the transaction, that portion becomes a taxable event.
What constitutes a “like-kind” property? The term “like-kind” property refers to two real estate assets of a similar nature regardless of grade or quality. The IRC defines a “like-kind” property as any held for investment, trade or business purposes. This means both properties involved in the exchange must be for business or investment purposes. Personal residences do not qualify.
There are no limits to how many times one can perform an exchange. Upon the death of the property owner, the heirs inherit the property at a stepped-up basis, thereby having no tax implications.
1031 Exchanges allow investors to grow investments tax-deferred, creating wealth and often disposing of one property to acquire a different one. Investors can purchase before selling (under certain circumstances) with a reverse exchange, or they can buy and sell simultaneously.
Since these transactions can be very complicated, most investors will use what is known as a Qualified Intermediary (QI). The QI is a professional who oversees the entire process. While it is strongly suggested one use a QI, I have actually known people that did not use a QI but found an attorney or banker willing to hold the funds. 1031 Exchanges can be very complicated and as with anything involving the IRS, if the rules are not completely followed, the IRS can step in and invalidate the exchange thus triggering an unexpected tax bill of capital gains for the investor.
The QI’s primary goal is to restrict access to the proceeds of the sale from the investor, ensuring an “arms-length” transaction. The QI becomes an escrow agent for the investment funds. The QI must be an independent entity – not the investor, the investor’s agent, and not related to the investor. Typically, the QI enters into a formal written agreement with the investor stating the process and the property(s) involved. Also the QI normally charges a percentage fee for their services. This should be seen as a normal cost of doing business as the QI protects the investor and ensures all guidelines and requirements regarding the exchange are followed.
The QI receives the relinquishing property from the Seller and transfers it to the Buyer. The QI retains the proceeds from the sale in their escrow account. Once the Seller of the relinquished property identifies their replacement property, it is acquired by the QI via the proceeds held in its escrow account. Then the acquired property is transferred to the Seller of the relinquished property.
In the following weeks we will discuss:
What Qualifies and What Doesn’t
Fees, Costs, and How Long it Takes
Timelines and Rules
Reverse and Partial Exchanges
Benefits and Drawbacks of an Exchange
What Happens When You Sell
What Does the Process Look Like
Alternatives to a 1031 Exchange