Property Exchanges conforming to IRC section 1031 offer wonderful opportunities to defer tax liability and maximize profits while helping to continue with the investment of the capital.
The IRC clearly states the main qualifying parameter of the exchange as a like-kind exchange. “In a like-kind exchange, the property you give up and the property you receive must be held by you for investment or for productive use in trade or business.” Thus, 1031 Exchanges can involve only like-kind of properties.
In all, there are five types of 1031 Exchanges. In Simultaneous Exchange one property is sold and the next is bought exactly the same time.
In Delayed Exchange, property is sold and the replacement property is bought within 180 days. Reverse Exchange has the replacement property bought before the initial property is sold.
Improvement Exchange uses some of the capital to improve the property, as in building a road. Personal Property Exchange can also come under ‘like-kind’ exchanges other than real estate. That includes cattle, aircraft, mineral rights, etc.
Just as there are several types of 1031 Exchanges, the processes in each of them vary substantially. Delayed Exchange is the most common type, and also the most popular.
In Delayed Exchange, the first step is planning out the whole transaction by talking to a qualified intermediary, otherwise called a facilitator. The facilitator then ascertains the investment objectives of the seller or exchanger and suggests the right option after estimating the amount of potential capital gains and the resultant tax outgo involved.
Drafting a standard purchase and sale agreement is the second step, stating the exchanger’s intent to exchange the property and obtaining the buyer’s consent to cooperate. The facilitator then suitably converts the sale transaction into an exchange deal through specialized documentation.
Having decided to perform an exchange, parties are then notified about the transaction and the intent to exchange. The parties involved are the real estate agent, closing agent, accountant and attorney.
The facilitator then collects the information required to prepare the exchange documents. The originals are then forwarded to the closing agent for execution during closing. All parties get the documents for review. After closing, the exchanger will transfer the relinquished property to the QI, who would then simultaneously sell the property to the buyer. The proceeds go to the QI and held by him until the acquisition of the replacement property is over.
In the Delayed Exchange, from the date of closing the relinquished property the exchanger gets 45 days to identify the replacement property and 180 days to complete the exchange. The identified replacement property is purchased by the QI and transferred to the exchanger in the stipulated time, making the exchange complete.
It is the facilitator, or QI, who answers all questions from the exchanger’s accountant or attorney. The exchanger’s funds are deposited in separate and insured accounts to ensure security, sometimes in a $1,000,000 fidelity bond account.
The exchange has to be done diligently so that it survives the audit and scrutiny of the IRS.