What is a 1031 Exchange?
A 1031 exchange is an IRS authorized process that allows owners of business and investment Real Estate to sell their property and buy other like kind property without paying the Capital Gains Tax. These transactions are known as deferred exchanges, or 1031 exchanges, and allow the investor to continue his or her investment in another property without loosing investment equity to taxes.
Section 1.1031 of the Internal Revenue Code laid out in detail the procedure for turning a sale and purchase type transaction into an exchange. These new rules allowed the owners of business and investment Real Estate to buy and sell their property on the open market, and by following these simple rules defer the payment of the Capital Gains tax.
The rules require that the property must be of “like kind” however the like kind provision for Real property is quite broad. It includes Land, Rental, and Business property. Any of which, can be exchanged for the other.
The rules also require that the "Exchanger" use a safe harbor to hold the proceeds while the exchange was in progress, and spells out what those safe harbors are.
How do I start the 1031 Exchange process?
After you have signed your purchase & sale contract, and made arrangements with title/escrow company or attorney to close your transaction, it's time to set up your 1031 exchange.
You must select a Qualified Intermediary (QI) to assist you and facilitate the 1031 exchange. One of the most important aspects of the process is the security of funds being held by the Qualified Intermediary. Make sure to select the Qualified Intermediary with the highest level of security, expertise and service.
How do I find a 1031 Exchange Replacement Property?
Please search our investment property pages at www.nnn1.com or contact us at 866-982-1031 to discuss your 1031 exchange requirement. We have access to properties all over the United States not listed on the site.
How long does a 1031 Exchange take?
In 1984, Congress amended the Code, adding a 45-day identification period and a 135-day exchange period time limit for like-kind exchanges. This action signaled their approval for delayed multi-party exchanges. Unfortunately, the IRS did not issue Regs dealing with deferred exchanges until spring 1991.
Identification and Exchange Periods
The Tax Reform Act of 1984 imposed two time limitations on §1031 exchanges. One limitation requires Replacement Property to be identified within a certain time. The other requires Replacement Property to be received by the exchanger within a certain time period. To successfully qualify for §1031 treatment, your exchange must satisfy both tests.
In a deferred exchange, any Replacement Property you receive will be treated as property which is not like-kind to the Relinquished Property if
the Replacement Property is not “identified” before the end of the “identification period”, or,
the identified Replacement Property is not received before the end of the “exchange period.”
The identification period begins on the date you transfer the Relinquished Property and ends 45 days after.
The exchange period begins on the date you transfer the Relinquished Property and ends on the earlier of 180 days after or the due date (including extensions) for your tax return for the taxable year in which the transfer of the Relinquished Property occurs.
Identification - How to Identify
Replacement Property is identified only if it is designated as Replacement Property in a written document signed by you. This document must be hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person (other than yourself or a related party) involved in the exchange.
An identification of Replacement Property made in a written agreement for the exchange of properties signed by all parties thereto before the end of the identification period will be treated as satisfying the requirements. It's not necessary for the agreement to be “sent” to a person involved in the exchange.
Alternative and Multiple Properties
There are limitations on how many replacement properties you may identify in the same deferred exchange, no matter how many relinquished properties you transfer.
You may identify more than one property as Replacement Property subject to two rules: the 3-property rule and the 200% rule. You only have to satisfy one of these rules—not both.
The 3-Property Rule
The maximum number of replacement properties you may identify is three properties without regard to fair market value of the properties.
The 200 Percent Rule
You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties.
You figure fair market value of Replacement Property as of the end of the identification period. You figure fair market value of Relinquished Properties as of the date you transfer them. If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified. However, there are two important exceptions to this rule:
It does not apply to any Replacement Property received by you before the end of the identification period, and
it does not apply to any Replacement Property identified before the end of the identification period and received before the end of the exchange period. However, to qualify for this exception you must receive identified Replacement Property constituting at least 95 percent of the aggregate fair market value of all identified Replacement Properties before the end of the exchange period.
What do I need to know about 1031 Exchanges?
Your exchange will be smoother and easier on you if you take a few moments to become familiar with the IRS rules and procedures governing Sec. 1.1031 exchanges.
The procedure and timing of the exchange is explained below.
PHASE I
1. Do some planning first, talk with your tax advisor (before you do the exchange), calculate your tax exposure to determine if this exchange is practical. You don't have to have your replacement property selected at this stage.
2. Complete your purchase & sale agreement just as you would with a regular sale.
3. When your agreement is fully signed you'll need to take it to the closing agent. (We call this step Opening Escrow). Make sure you tell the closing agent that this transaction is going to be a 1031 exchange.
4. Notify your QI about who is doing the closing.
5. Have the QI contact the closing agent and set up an Exchange file for you, process the 1031 Exchange documents, and send the documents directly to the closing agent. The closing agent will take it from there.
6. After the exchange sale is complete the closing agent will wire transfer the proceeds into the QI’s trust account. Upon receipt of these funds, and a copy of the final closing statement, they will send you a letter showing the amount of proceeds they received (this should be the same as the amount shown on the bottom of your closing statement). This letter will also include the dates of the 45 & 180 day periods.
PHASE II
1. Before the end of the 45-day identification period, send a list of the replacement property you wish to identify. This can be on the form the QI supplied, or on any other similar written document. You can mail, E-mail, or Fax it. Make sure it's fully signed by each named "Exchanger".
2. Write & sign your purchase & sale agreement(s) adding the "Exchange Clause" as you did in the first transaction. Again open escrow as you did in the first transaction; notify the closing agent that this transaction is a 1031 exchange, and name your Qualified Intermediary.
3. Again, notify the QI as to who the closing agent is. Also tell them how much of your proceeds you want to use on this transaction, and approximately when your purchase will close.
4. The QI will then contact the closing agent and send the exchange closing documents directly to the closing agent. After the closing documents have been signed by all parties, the closing agent will send the QI signed copies, and they will wire transfer the proceeds into escrow. The closing can then be recorded, and you have completed your exchange.
5. The closing agent should give you copies of all the documents, including the exchange documents used in your transaction. When you have closed on the last identified property, or at the end of the 180-day period, your exchange ends and the QI will return any unused proceeds. You should try to use all of your proceeds, the returned proceeds are referred to as "boot" and are taxed on their full amount.
6. When you file your taxes the form you will use to report your exchange is: IRS form 8824 "Like-Kind Exchanges".
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