By electing a 1031 Exchange, certain real estate held for investment or productive use in a trade or business may qualify for the deferral of tax liability normally due on its disposition or transfer of ownership.
“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). Plain-language translation: Any gain realized on an exchange of like-kind property will not be taxed until you “cash out” of your investment.
How it all started: Starker vs. United States
If you want to read about this landmark case, just Google it. IRC Section 1031 has been part of the IRS Code for decades upon decades! 1031 Exchange was not popular prior to this case because it was very difficult to perform until certain guidelines were put into place because of the outcome of the famous Starker Case. That is why a 1031 Exchange is commonly referred to as a “Starker Exchange.” All the way back in 1967, this landmark case began the evolution of what is today IRC Section 1031 Exchange. This section of the code is described in layman’s terms below for your ease of use and understanding. Although the definitions and terms below are basic, IRC Section 1031 when properly mastered provides for so much more than can be printed in this book, so be sure to ask!
The Basics of an Exchange
The election to do a 1031 Exchange is made by contacting (and entering into an agreement with) a Quali ed Intermediary (QI) to act as a third-party facilitator. This MUST be done prior to the transfer of the relinquished property. To have a fully tax-deferred exchange, the exchanger should:
Purchase “like-kind” replacement property of equal or greater value than the relinquished property
Reinvest all of the net equity (exchange funds) from the sale of the relinquished property in the purchase of
the replacement property
Obtain equal or greater debt on the replacement property that was paid off, assumed or taken subject to
the relinquished property sale
Once the relinquished property is transferred, the law allows the taxpayer 180 calendar days (or until the ling of the tax return for the year of the sale of the relinquished property, whichever comes rst) to complete the acquisition of “like-kind” replacement property. All timelines begin at the time the relinquished property is transferred.
The Timelines and Identification Period
The next 45 calendar days of the Exchange are known as the Identification Period during which the taxpayer must identify in writing to the QI what property he or she would like to have eligible for the Exchange. Even though he or she need not have the property in escrow nor does the property even have to be listed for sale, it is suggested due to the strict timeframes that negotiations should already be taking place before the 45th day. Failure to identify property by the close of business on the 45th day could void and fail the Exchange!
There are three methods for identifying property, depending on what your goals are in the Exchange. The taxpayer may ultimately only select one of the three methods by the 45th day. Properties on these lists may change only up to the 45th day, and no changes may be made afterward.
The Three Methods
The 3 Property Rule – Three properties of any value may be listed regardless of their value. One, two, or all three properties may be acquired.
200% Rule – Four or more properties may be listed; however, their cumulative FMV (fair market value) may not exceed 200% of the value of the relinquished property. One or more of the properties may be acquired.
95% Exception – Any number of properties of any value may be listed; however, 95% of the property MUST be purchased.
The Exchange Process
Exchange either at the time Escrow is opened or preferably before contacting QI to discuss transaction and open the Exchange.
Documents are sent out to investor for review and also to the Escrow company ( ve to seven days before COE).
QI coordinates with Escrow to have investor sign Exchange documents and provides Escrow company with instructions for transfer of Exchange Proceeds.
Once funds are received by the nancial institution a “receipt of funds” noti cation is sent to the investor along with ID documents and instructions.
Investor locates suitable replacement property and submits ID letter.
Investor opens Escrow for purchase of replacement property.
Investor submits request for Earnest Money Deposit Funds.
Investor submits Replacement Property Information Form with all needed information regarding the replacement property to the Escrow company.
QI coordinates with Escrow on replacement property and obtains instructions to transfer Exchange funds to the closing of the property per the investor’s desires.
Investor closes as normal on the property and obtains all usual documents customary in the purchase of real property.
Investor supplies all settlement statements and required documents to his or her CPA or tax advisor for proper reporting to the IRS.