Frequently Asked 1031 Exchange Questions
By participating in a 1031 Exchange, the owner of property has additional capital for the acquisition of their replacement real estate. This additional capital can increase cash flow for the owner or allow them to purchase a higher valued replacement property.
There are also benefits to the economy as a whole. The transaction generates business for settlement agents, real estate professionals, attorneys and tax professionals. It also generates state and local taxes generated by additional transactions.
The 1031 Exchange, also known as a tax-deferred exchange, comes from IRC section 1031, which was written back in 1921. This tax code allows taxpayers to exchange property held for business use or investment purposes for other like-kind property. As long as the taxpayer meets the necessary requirements, the taxpayer will not recognize the gain from the sale of the asset.
Tax rules require that a taxpayer enlist the assistance of a Qualified Intermediary (QI) for their 1031 transaction. The QI will fill two roles in the transaction. First, they will prepare documents before the sale of the relinquished property and they will also document the replacement property closings. Second, the QI will hold the funds on behalf of the client during the exchange. The QI will disburse funds for the acquisition of the replacement property and if there is a balance after the purchase, the QI will return the unused funds to the taxpayer at the end of the exchange period.
The IRS requires that a taxpayer enlist the assistance of a Qualified Intermediary before the closing of their relinquished property. If not, the taxpayer will have actual or constructive receipt of the sales proceeds. It is important that a taxpayer disclose in their purchase and sales agreement that they intend to make the transaction a part of a 1031 Exchange. As long as the sale has not closed, the 1031 Exchange can still be set up in line with the IRS code.
In the 1031 process, taxes are only deferred, not eliminated. You will eventually need to pay your taxes when you sell your replacement property and do not do another 1031 exchange.
A Reverse Exchange is when a taxpayer needs to acquire replacement property before selling their relinquished property. In a case like this, a Qualified Intermediary will need to take title on behalf of the client to either the relinquished property that they will be selling in the future or to the replacement property that is being acquired first. The taxpayer is not allowed to hold title to both properties at the same time.
As further defined in Revenue Procedure 2000-37, if the taxpayer is acquiring replacement property first, they will also need to coordinate the down payment, either with funds out of pocket or a combination of out of pocket funds and a loan. If a lender is involved, having a QI take title to the replacement property could be problematic.
Reverse Exchanges do take more planning on the taxpayer’s part along with their counsel or CPA. These transactions also cost more than a standard 1031 Exchange. But having the benefit of acquiring property first can outweigh any other issues.
Improvement Exchanges allow taxpayers to use proceeds from their relinquished property to acquire and to improve their replacement property.
Some items to consider when thinking about this type of exchange are:
- The improvements to the replacement property must be identified with the Qualified Intermediary within the 45 day Identification Period, along with the standard identification of property.
- At the closing of the acquisition of the Replacement Property, the QI will create an LLC and take title to the replacement property. When the improvements are completed within the 180 day exchange period, the QI will transfer ownership of the property back to the client.
There may be additional costs to the taxpayer, including a higher exchange fee, additional title insurance premiums, transfer taxes and possibly loan costs.