UNDER Section 1031 of the United States Internal Revenue Code, 26 U.S.C. §1031, the exchange of properties used for investment or trade or business, but not for personal use, may defer the recognition of capital gains or losses due upon sale, and defer payment of capital gains taxes otherwise due.
It should be emphasized that to qualify for Section 1031 exchange, the properties exchanged must be held for productive use for investment or in a trade or business. Certain properties such as stocks, bonds, and livestocks of different sexes are excluded, or considered not like-kind properties.
The properties exchanged must be of the same class, nature or character, that is, of “like-kind”, even if they differ in quality or grade. But properties in or used in the United States and properties outside or used elsewhere are not like-kind properties.
Cash to equalize a transaction called “boot” is not of like-kind and is taxed at 15% federal capital gains rate. And any realized gain by the seller-taxpayer from excess liabilities assumed by the buyer is likewise subject to capital gains tax.
Non–simultaneous exchange procedure
The taxpayer selling the property must include a “Cooperating Clause” in the purchase agreement which states the seller’s intention to complete a 1031 exchange and the buyer agrees to cooperate with the seller to accomplish the exchange.
The taxpayer-seller must also enter into a 1031 exchange agreement with a “Qualified Intermediary”, who is named as the “principal” in the sale of the relinquished property and the subsequent purchase of the replacement property.
The escrow instructions should name the Qualified Intermediary as the seller. Once the relinquished property escrow closes, the proceeds of the sale go to the Qualified Intermediary.
The transfer deed is signed by the taxpayer-seller and is recorded through escrow.
The funds of the sale are placed by the Qualified Intermediary in a separate market account for safety and liquidity purposes.
Next, the taxpayer-buyer enters into a purchase agreement on the replacement property, again with a “Cooperating Clause”, which states the buyer’s intention to complete a 1031 exchange and the seller agrees to cooperate to accomplish the exchange.
The Qualified Intermediary is named as the buyer. When all the conditions of the purchase are satisfied and before escrow closes, the Qualified Intermediary forwards the exchange funds to escrow.
The closing statement prepared by escrow states that the Qualified Intermediary is the buyer. The Qualified Intermediary then sends a final accounting to the taxpayer, showing the funds from the relinquished property escrow and going to the replacement property escrow, without any constructive receipt by the taxpayer.
The taxpayer files Form 8824 with the Internal Revenue Service when taxes are filed, when the exchange’s tax return is due (including extensions) for the taxable year in which the relinquished property is transferred to the buyer.
§1031 Exchange time limits:
The Section 1031 exchange period begins with the closing date of the relinquished property as day 0 of the exchange. Within 45 days of the beginning of the exchange period, a written identification of the address of the replacement property must be sent to the Qualified Intermediary.
The written identification of the address of the replacement property must be signed by everyone who signed the Exchange Agreement and sent by certified mail, return receipt requested to the Qualified Intermediary, the seller of the replacement property or his/her agent or attorney.
The identified replacement property must be acquired by the taxpayer within 180 days of the exchange period, that is, 180 days from the closing date of the relinquished property escrow.
Section 1031 like-kind exchanges are complex and require the active participations of competent sales persons / brokers, Qualified Intermediaries, and even real estate / tax attorneys.
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The Author, Roman P. Mosqueda, has practiced Real Estate law for over 20 years. He has been a licensed Real Estate Broker in California since 1999. Send comments [email protected] or call (213) 252-9481 for free consultation appointment. Visit Mosquedalaw.com and EzineArticles.com to read his other articles.