1031 Exchange Definition
The Internal Revenue Code §1031 provides for a so-called "like kind" exchange of properties, which would not require the taxpayer to pay taxes on a sale if a replacement property ("replacement") is bought. The purpose of this type of exchange is to enable a person or organization to preserve their equity at a lower tax burden. Essentially, the capital gains tax on the sale of the relinquished property is wheeled away when the new asset is acquired. Investors allow their properties and others’ income to grow under tax deferral. Although taxpayers do not have to pay taxes in this instance, they will likely be required to use their equity on the acquisition of another property.
Specifically, this tax-code exception is only allowed if proceeds that were meant to obtain the replacement are given up and so are those tax burdens. If the tax return recognizes that the tax burden was wheeled away, the IRS cannot claim the taxpayer "pocketed" the tax owed on the relinquished property.
Let’s say, for example, a person owns a portfolio of 5 rental properties. The total profit accrued from the sale of these 5 properties amounts to $2 million. Out of the $2 million of profit, there is $1.5 million of capital gain attributable to depreciation and appreciation. The $500,000 capital gain would be taxed at the rate of 15%, so the tax would be $75,000. If the capital gain is instead deferred by utilizing a like kind exchange, the taxpayer effectively keeps $75,000 in their pocket.
In order for a like kind exchange to work, the relinquished property (usually called a "relinquished") must equal or exceed the value, equity, and debt balances of the replacement. If the taxpayer has debt on the relinquished, the equivalent in debt on the replacement is needed to qualify for the exchange . Consequently, if the debt from the relinquished is gone before the replacement is bought, it can cause problems. If the interest on the debt from the relinquished was tax-deductible, you should make sure to acquire the appropriate amount of tax-deductible debt or keep a similar level of debt on the replacement property for maximum tax benefits.
The 45-day identification and 180-day exchange deadlines must be satisfied for a valid exchange. The property or properties that the taxpayer is expecting to receive must be listed within 45 days, prior to the paperwork for the sale of the relinquished being finalized. The paperwork validating the actual completion of the exchange must be filed before the 180th day passes, which is generally accepted as the legal date for the closing of the sale.
Each party’s name on the closing documents of the sale of the relinquished property and the replacement must be identical. If the relinquished was owned by a limited liability company (LLC), or land trust for tax-profiled reasons, the replacement must be owned by a limited liability corporation or land trust too. If the relinquished is held as a single member LLC, the replacement must also be held as a single member LLC. If the relinquished is held by a limited partnership (LP), the replacement must be purchased by the LP as well.
The IRS, together with the Department of Labor, can penalize you even when specifications regarding the valid exchange are not adhered. The consequence of non-compliance with the 5-, 7-, and 10-year holding rules can result in the taxpayer being penalized with a 20 percent accuracy-related penalty if one is convicted of making a considerable overstatement. The taxpayer may also have to give up the tax deferment.
Critical 1031 Exchange Paperwork
The success of 1031 exchanges often hinges on whether a taxpayer has the right documents — and whether those documents are executed and delivered in a timely manner. The following are the primary documents involved in a 1031 exchange.
Purchase and Sale Agreement. This is the document that a "best practices" Qualified Intermediary (QI) or exchange facilitator will need in order to prepare a true exchange agreement. While investors can use an existing Purchase and Sale Agreement, the better practice is to have the QI prepare a new document expressly indicating that the sale is pursuant to a 1031 exchange. This is so that if a contract was previously prepared before qualified advice was received, a new contract can be drafted and executed to protect the investor. The requirements for a valid Purchase and Sale Agreement are:
Assignment Agreement. This document can be used to assign the right to purchase the Relinquished Property to the QI. The investor can also sign a document appointing the QI as attorney in fact over the transaction. This will ensure that the rights under the Purchase and Sale Agreement will be transferred pursuant to the Exchange Agreement described below. Although the taxpayer chooses which type of assignment document is to be used, it is important to have a QI draft the appropriate document since if the wrong one is signed, the exchange may be jeopardized.
Exchange Agreement. This is an agreement between the investor and the QI. In addition to having the QI act as the "investor’s attorney in fact, it also provides instruction to the QI.
Role of the QI (Qualified Intermediary)
Qualified Intermediary (sometimes called a "facilitator" or "Q.I.") is the 1031 exchange vendor who actually performs the complex and tedious exchange administration responsibilities and documentation requirements under the applicable 1031 code. When considering your 1031 exchange, you must understand and appreciate the many essential roles played by both you and your exchange professional. The role of the Q.I. is to first determine the nature of the exchange you wish to make or are required to make (full or partial exchange) and then to provide all of the necessary documentation and instructions so that the transaction is properly structured (as an exchange) and services properly performed (at the Q.I.) to satisfy all of the numerous IRS requirements.
A good 1031 exchange Q.I. will perform their responsibilities pursuant to either your specific written formal engagement or, if you are just working with them to learn more about 1031 exchanges, a written proposal for you to exchange with them once you are ready. The initial documentation to be provided by the Q.I. typically will include: a Q.I. application form, letter of intent and/or agreement, W-9, questionnaires concerning the property involved, your lenders, etc. and possibly a required questionnaire for non-individual sellers or buyers. An exchange Q.I.’s service terms, pricing and organization vary significantly in this country. Always explore your options carefully. An exchange documentation package is typically drafted, reviewed by you and the seller/exchanger’s counsel, finally executed by the parties only after the transaction closes and may be re-examined (even modified) by the Q.I. on various occasions throughout the process – especially the closing process. A Q.I. also may provide administrative services relative to the closing process including funds handling and distribution services. A good 1031 exchange practitioner will advise you on acceptable procedures for you to follow relating to the exchanging of your property and the identification and purchase of the replacement properties.
Deadlines and Timelines
With limited exceptions, taxpayers who have engaged in a 1031 exchange have a very limited amount of time to complete the exchange process. The basic plan for a 1031 exchange usually provides that the taxpayer has 45 days from the transfer of the first property in order to identify a replacement property in writing. This writing must be signed by the taxpayer and unambiguously describe the replacement property. Because strict adherence to the 45-day requirement is necessary for a successful exchange, too often taxpayers simply do not have sufficient time to identify a replacement property. This is why, as discussed above, it is best to make as many plans as possible for a replacement property prior to engaging in an exchange.
In addition to the identification requirement, a taxpayer must complete the exchange on or before the earlier of either (i) 180 days after the transfer of the relinquished property or (ii) the due date for the transferor’s tax return for the tax year in which the relinquished property is transferred. It is clear that due to this deadline, an extension of time to file the tax return will not extend the period allowed to complete the exchange. Payment of extensions may extend the taxpayer’s time for filing a return , but will not affect the end date for the 180-day exchange period.
Since some of the deadlines discussed above overlap, it is important to remember that while the required identification of the replacement property must be completed within 45 days, the exchange period is often longer than 180 days. For example, in an exchange in which the relinquished property is sold on July 1, and the taxpayer’s tax return is due September 1, and is timely filed, thus extended to October 15, the taxpayer will have 136 days (from July 1 to October 15) to complete the exchange. Included in these 136 days is the 45-day identification deadline, which only leaves 91 days to close the acquisition of the replacement property.
The completion deadline is critical because under certain circumstances, if a timely identification is made (i.e. within 45 days), but the replacement property is not actually acquired until after the expiration of the 180-day exchange period, the failure to acquire does not prevent the taxpayer from qualifying for non-recognition treatment under Internal Revenue Code section 1031.
Therefore, without timely acquisition, a taxpayer cannot qualify as having received property in a 1031 exchange transaction. As such, it is critical to understand that these timelines are critical in a 1031 exchange and are non-negotiable.
Mistakes and How to Avoid Them
So while the creation of 1031 Exchange documents is important and central to the 1031 process, don’t forget that these documents have to comply with the laws. Do not take it upon yourself (briefcase in hand) to go to the recording office and file documents that weren’t prepared by a professional. You could cause yourself, and the Qualified Intermediary, all kinds of legal headache and problems just by being too proactive. We recommend that you make sure that the most qualified professionals are preparing the 1031 Exchange documents so that you have a timely closed exchange.
Takeaways and Best Practices
In summary, maintaining accurate and comprehensive 1031 exchange documents is essential for a successful exchange. Some best practices for managing your 1031 exchange documents during the exchange process include: staying organized, working with your team to keep all documents current, and seeking professional guidance from qualified attorneys, brokers, and accountants . A 1031 exchange can be a complex process, but being diligent with your documentation can help prevent potential pitfalls and maximize the benefits of this powerful tax strategy.