What is a typical Section 1031 Exchange?
To accomplish a 1031 exchange, there must be an exchange of properties. The simplest 1031 exchange involves a contemporaneous swap of one property for another. Often the closings on both properties occur at the same title company on the same day.
Who qualifies for a Section 1031 exchange?
Owners of investment and business property – including individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity – can qualify for a Section 1031 deferral.
What property qualifies for a 1031 Exchange?
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
- Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like your home or vacation homes, does not qualify.
- The properties exchanged must be “like-kind”.
What types of property cannot be exchanged?
Section 1031 does not apply to exchanges of:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
Can I be my own “Exchange Agent/Intermediary?”
No. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator either. However, Brazos 1031 would be happy to help you.
How to Begin the Process of a 1031 Exchange
In order to start a 1031 exchange, you need to take a few steps. The most important is you need to hire an exchange agent prior to your first closing. In fact, ideally your exchange agent will be consulted prior to even signing the first contract (whether buying or selling).
For the property you are selling, you will want to include some language about your use of a 1031 exchange in the earnest money contract. This contract language is called the “cooperation clause.” For example, to use Brazos 1031 Exchange Company, you should include the following language:
“The Buyer acknowledges that it is the intention of the Seller to effect an IRS Section 1031 Tax-Deferred Exchange and that the Seller's rights under this agreement shall be assigned to Brazos 1031 Exchange Company, LLC, to facilitate such exchange. Buyer agrees to cooperate with the Seller and/or its assigns in a manner necessary to enable the Seller to initiate said exchange at no additional cost or liability. “
Similarly, for the property you are buying, you will need to include the following language:
“The Seller acknowledges that it is the intention of the Buyer to complete an IRS Section 1031 Tax-Deferred Exchange and that the Buyer's rights under this agreement shall be assigned to Brazos 1031 Exchange Company, LLC, for the purpose of completing such exchange. Seller agrees to cooperate with the Buyer and/or its assigns in a manner necessary to complete said exchange at no additional cost or liability. “
If you forgot to include this language in the contract, it is okay. You can still do a 1031 exchange, but you will need the opposing party to agree to sign some paperwork related to your 1031 exchange. It is better practice to include the Cooperation Clause so that it is part of the bargain and the opposing party is agreeable at the outset.
If you need help with a 1031 exchange, contact us through our online contact form.
What are the typical steps I have to take to complete a 1031 Exchange?
The typical steps you need to take are:
- Owner and buyer sign sales contract for property with a cooperation clause
- Owner and/or their Realtor retains Brazos 1031 Exchange Company before closing.
- Owner signs Brazos 1031 Exchange Company's exchange documents at the title company during closing on the property being sold (“Relinquished Property”).
- Sale proceeds are wired to Brazos 1031 Exchange Company's client trust account.
- Owner identifies new investment property (“Replacement Property”) within 45 days of closing.
- Brazos 1031 Exchange Company closes on replacement property within 180 days of original sale (unless due date is extended).
- Property is directly deeded to Owner and the exchange is complete.
- Owner reports the transaction on his tax return in the year in which the Relinquished Property was sold.
How much time do I have to complete the exchange?
There are 2 time limits that apply. First, you have 45 days from the date you sell the relinquished property to identify potential replacement properties.
Second, the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.
Can these time limits be extended?
No, except in cases of Presidentially-declared disasters. Of course, we would not recommend banking on one of those to occur.
What is a Deferred Exchange?
A Deferred Exchange is a more complex, yet more flexible, variation of the typical 1031 Exchange. A Deferred Exchange allows you to dispose of property and subsequently acquire one or more other like-kind replacement properties. To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).
In a Deferred Exchange, the disposition of the relinquished property (which is being sold) and acquisition of the replacement property (the property being bought) must be mutually dependent parts of an integrated transaction. What this means is that the taxpayer will enter into an exchange agreement or contract using an exchange facilitator (like Brazos 1031) to both sell their property and acquire the new property within the IRS rules governing 1031 exchanges. If this is done correctly, the Deferred Exchange qualifies as a 1031 exchange.
How a Delayed 1031 Exchange Works
By following the procedures prescribed by IRC Section 1031, an investor can defer paying capital gains tax when selling investment property and can transfer all of the equity in the investment property (the “relinquished property”) into a new property (the “replacement property”).
To defer capital gains tax, the investor or “taxpayer” must avoid the receipt, or even the possibility of receipt (which is called “constructive receipt”), of the proceeds from the sale of the relinquished property. This is done by using an independent party (called a “qualified intermediary”), such as Brazos 1031 Exchange Company, to facilitate the exchange. The intermediary may not be the taxpayer's attorney or real estate agent.
The simplest type of Section 1031 tax deferred exchange occurs when the taxpayer sells the relinquished property and acquires the replacement property at the same time. In fact, both closings can occur on the same day.
But what happens when the taxpayer finds a buyer for the property to be relinquished, but has not yet located a replacement property to complete the exchange? By following the following steps, a delayed tax deferred exchange can be accomplished.
- The taxpayer enters into a sales contract with the buyer of the property to be relinquished.
- The taxpayer assigns its position in the contract to the intermediary.
- The buyer pays the purchase money to the intermediary.
- The taxpayer deeds the relinquished property directly to the buyer.
- The taxpayer notifies all parties of the identity of the replacement property within 45 days thereafter.
- The taxpayer enters into a purchase contract with the seller of the replacement property.
- The taxpayer assigns its position in the contract to the intermediary.
- The intermediary pays the purchase money to the seller out of the funds the intermediary received from the buyer of the relinquished property.
- The seller of the replacement property deeds the property directly to the taxpayer within 180 days after taxpayer deeds the relinquished property to the buyer.
In order to ensure your transaction is fully tax-deferred, you should look to exchange “up” in value, meaning that the market value of the replacement property is greater than that of the relinquished property, and any debt associated with the replacement property is greater than that of the relinquished property.
A Texas property exchange expert can guide you through the requirements of properly structuring your transaction. If you or someone you know is about to sell investment property contact the experienced experts at Brazos 1031 Exchange Company, LLC.
What is a Reverse Exchange?
Just like it's name sounds, a Reverse Exchange is the opposite of a Deferred Exchange. It involves the acquisition of replacement property (the new property) through an exchange accommodation titleholder, with whom it is “parked” for no more than 180 days. During this 180 day period, the taxpayer disposes of its relinquished property (the old property) to close the exchange. Basically, in this form of exchange you are buying the new property before selling the old property. Like the Deferred Exchange, the taxpayer enters into a contract with an exchange facilitator (like Brazos 1031) and follows the strict requirements of the IRS rules.
How Does a Reverse 1031 Tax Deferred Exchange Work?
In a typical tax deferred exchange, the taxpayer sells the relinquished property and either contemporaneously or later acquires the replacement property. This process is reversed in what is called a “reverse exchange.” In this permutation of the exchange process, the replacement property is purchased before the relinquished property is sold. In the typical reverse exchange, the taxpayer identifies the replacement property and obtains the agreement of a third party, called an “exchange accommodation titleholder,” to take title to the replacement property on the taxpayer's behalf before the taxpayer sells the relinquished property.
A taxpayer may want to use a reverse 1031 exchange for several reasons: (1) the taxpayer has not yet found a buyer for the property to be relinquished; (2) the taxpayer must close on the replacement property by a certain date to obtain favorable financing or avoid forfeiting a deposit; or (3) improvements need to be made on the replacement property.
The IRS has published procedures that provide what is called a “safe harbor” in a reverse exchange. Compliance with this safe harbor provides assurance to the taxpayer that the characterization of the properties involved in the transaction, and their interim ownership by the titleholder, will be deemed in compliance with IRC Section 1031. An exchange that does not comply with the safe harbor rules may or may not qualify for tax-deferred treatment.
The safe harbor is satisfied if an “accommodation arrangement” is made pursuant to which the following requirements are met (note: these are an abbreviated version of the most relevant requirements):
- Title to both the replacement and the relinquished properties are held by an independent qualified accommodator.
- The taxpayer has a bona fide intent that the property so held is either replacement or relinquished property that is intended to qualify for tax deferment.
- No later than 5 days after the accommodator takes title to the replacement property, the accommodator and the taxpayer enter into a written agreement that provides that the accommodator is holding title to the replacement property for the benefit of the taxpayer in furtherance of a section 1031 tax-deferred exchange.
- No later than 45 days after title to the replacement property is transferred to the accommodator, the taxpayer identifies the property to be relinquished.
- No later than 180 days after title to the replacement property is transferred to the accommodator, the title is transferred again, this time to the taxpayer.
- A final step also contemplated is that the relinquished property is transferred to the taxpayer's buyer.
The regulations and procedures prescribed by the IRS for reverse exchanges are complex and reason to employ the services of a Texas property exchange expert in any such transaction. If you are planning to sell and acquire investment property, contact the experienced experts at Brazos 1031 Exchange Company, LLC.
What does “like-kind” mean?
Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
Can I use a 1031 exchange to buy property in another country?
No. Property in foreign countries is not considered “like-kind” to property owned in the United States.