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
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.
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).
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.
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.
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.
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.
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.