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IRC 1031 Exchange – What is it?

The 1031 exchange allows an investment property owner to sell a property and defer the recognition of capital gains (or losses) due on sale, and therefore defer any capital gains taxes due.

 

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."

        IRC §1031 (a)(1)

IRC 1031 Exchange – How does it work?

· Step 1 – Sale of Original Property

 In the ratified contract the seller will need to include a Cooperation Clause which notifies the buyer that the seller is engaging in a 1031 exchange and the buyer will cooperate in that effort at no additional cost or liability to the buyer.  The Cooperation Clause will also notify the escrow officer that this transaction will be part of a 1031 exchange

 

· Step 2 – Locate Qualified Intermediary (QI)

 The qualified intermediary is the entity that will hold the sales proceeds from escrow and is named as the principal in the sale of your property.  It is important to use a qualified intermediary that is bonded and insured against errors and omissions

         (Problems / Precautions for QI’s)

 

· Step 3 – Close of Escrow (Sale)

o Proceeds from escrow held by QI

 At the close of escrow, the qualified intermediary will be listed as the seller on the closing statement and the funds will go to the qualified intermediary.  The QI will then place the funds in a completely segregated money market account.  

          (If proceeds don’t go to the QI)

 

o Exchange Timeline Begins

 The close of escrow signals the beginning of the exchange timeline.  The entire 1031 process must be completed within 180 days of the close of escrow.  Also, the new property or properties to be purchased must be identified within the first 45 days of the 180 day timeline.  The purpose of the remaining 135 days are only to close escrow on the purchase property(s).

         (If you miss the 45 or 180 day timeline)

 

· Step 4 – Identify Replacement Property / Properties

o Like Kind Property

 IRC 1031 states the the exchange property must be a “like-kind” property that must be “held either for productive use in a trade or business or for investment.”  Any type of real property is allowable such as raw land, residential property, apartments, office buildings, shopping centers, etc as long as they are held for investment purposes.  Private residences and vacation homes are not allowable.  

          (If you purchase non “like-kind” property)

 

o Written notification to QI

 The taxpayer needs to send the address or legal description of the identified properties to the qualified intermediary on or before the 45th day of the exchange by fax, mail or hand delivery.  It is recommended to have proof of receipt.  

          (If you do not make your identification known to QI)

 

o 3 Property or 200% Rule

 The taxpayer may either identify 3 (or less) properties of any market value, or any number of properties as long as the aggregate value of the acquired properties does not exceed 200% of the value of the relinquished property(s).  If three or less properties are identified the taxpayer may close on 1, 2 or 3 of those properties.  However, if more than 3 properties are identified, the taxpayer is required to close on 95% or more of the identified properties.

         (If you violate the 3 Property or 200% Rule)

 

· Step 5 – Close of Escrow (Purchase)

o Another Collaboration Clause

 In the purchase contract the buyer must place a Cooperation Clause similar to that placed in the contract during step 1.  The collaboration contract will notify the seller that the buyer is engaging in a 1031 exchange and the seller will cooperate in that effort at no additional cost or liability to the buyer.

         (Unscrupulous Sellers)

 

o QI sends funds to escrow

 The qualified intermediary sends the funds to escrow and the closing statement will show the QI as the property buyer.  At close of escrow the qualified intermediary will transfer the property to the taxpayer.

 

 

Created by David Mollo - 2008

More information on 1031 exchanges

 

From the National Association of Realtors

 

From the I.R.S.

 

1031 Exchanges