In general, a “1031 Exchange” refers to the Internal Revenue code section 1031 that offers a real estate investor or trade or business owner the opportunity to defer ALL their capital gains tax owed from the sale of an investment or trade or business property. According to the Private Exchange Group, a company that specializes in 1031 Exchanges, here are the 8 steps in the process:
1. To take a 100% deferral of the Capital Gains and Depreciation Taxes, the Investor (also known as the Exchanger) has to reinvest ALL the equity and debt from the sale of the property into another investment property of equal or more value.
2. The property the Investor/Exchanger sells is called the Relinquished Property.
3. The property the Investor/Exchanger buys with the proceeds is called Replacement Property.
4. To avoid issues about the validity of handling the exchange, the option that is most frequently used is for the Exchanger to hire a third party known as a Qualified Intermediary (also known as a Q.I., Accommodator or Facilitator) to do the necessary paperwork for both transactions, hold the proceeds in an escrow account and make such funds available for the purchase of the new property.
5. Both the Relinquished and Replacement properties have to be investments or used in a trade or business. For 1031 Exchanges dealing with real estate (they can be used for other property), the real estate can be land or an improved property. If the property is an improved property, then there should be either a rental history or at least a legitimate attempt to rent it out or use it in a trade or business. A primary residential home or “flipped” properties are not eligible.
6. The Exchanger is bound by a strict timeline to close on both transactions:
a. The Exchanger has 45 calendar days from the close of escrow on the Relinquished Property to provide written identification to the Intermediary of up to three properties he/she is considering buying as a Replacement Property. If the Exchanger needs to identify more than three properties, additional restrictions apply.
b. The Exchanger has 180 calendar days from the close of escrow on the Relinquished Property to close escrow on whichever identified property(ies) are to be used as the Replacement Property.
7. At the closing of the Relinquished Property the Exchanger and Intermediary sign a “Like-Kind Exchange Agreement”. This establishes their relationship. The Exchanger and Intermediary sign an “Escrow Instructions” document, defining the handling of the escrow. The Exchanger and Buyer sign an Assignment of Contract, which assigns the contract to the Intermediary. When the Relinquished Property closes, the proceeds are wired to the escrow account of the Intermediary. It is on this transaction that the Intermediary usually collects their fee.
8. When the Exchanger sets up the closing on the Replacement Property, the Intermediary coordinates with the closing agent to wire the money for the closing and send the necessary documents for the closing.
To learn more about this process, watch this webinar with Drew Monoghan, President of The Private Exchange Group.
