In a 1031 Exchange an investor sells his property, called “Relinquished Property,” to acquire a “Replacement Property” without attracting tax on capital gains.
The whole exchange is overseen by a Qualified Intermediary (QI), a middle-man who provides services of paperwork, oversight, escrow and expertise to ensure that the transaction conforms to Rules under Section 1031 of the Internal Revenue Code.
Now, let us see what all properties qualify for 1031 Exchange. Real estate in general, for income tax purposes, has been divided into four categories- business use, investment, personal use and outright sale. Of them, the last two are unfit for 1031 Exchange.
Then comes the foremost stipulation: the new investment must be in a like-kind property. But this is not a blanket barrier either. It does not restrict that the exchanged properties must be like the photocopy of the other property in all respects, as in a bare land for bare land situation. It can be any real property held for investment or trade or business that can qualify for this exchange with a similar kind of real property used in trade or business.
After the sale of the first property or relinquished property, the investor must identify the replacement property in 45 days from the date of transfer of the relinquished property. This period is called “Identification Period” and the whole exchange must be over in 180 days, known as the Exchange Period.
A maximum of three properties can be identified for possible exchange. The binding Rule is that their aggregate fair market value (FMV) at the end of the identification period should not exceed 200 percent of the aggregate fair market value of all relinquished properties on the date of transfer of the relinquished properties.
There are exceptions too. In some cases, if a replacement property is received before the end of the identification period, that too will be treated as properly identified even if the three-property Rule and 200% Rule are being violated.
In that case, the fair market value of that replacement property must be at least 95% of the aggregate fair market value of all the identified replacement properties. This is known as the “95 percent Rule.”
In the exchange, it is compulsory that the investor has to reinvest all the proceeds from the sale of the relinquished property. If the exchanger fails to do so, the balance “cash boot” becomes taxable as capital gain.
The investor must always acquire the replacement property with equal or greater debt. If the exchanger does not acquire a replacement property with equal or greater amount of debt, the IRS deems it as reduction in debt and a benefit accruing to the exchanger, hence taxable, until and unless it is offset by adding equivalent cash to the replacement property purchase.
So it turns out that it is the qualified intermediary who holds the key to the entire transaction and makes sure that all proceeds of the sale of first property is reinvested and all Rules are strictly followed and equity is preserved. Having the best QI at your service then becomes the key to a successful 1031 exchange.