Pacific Investment Properties
A Reputation Built on Experience and Success
The Tax Deferred Exchange
The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers real estate investors one of the last great investment opportunities to build wealth and save taxes. By completing an exchange, the investor (Exchanger) can dispose of their investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of their equity into the replacement property. Two requirements must be met to defer the capital gain tax: (a) the Exchanger must acquire "like kind" replacement property and (b) the Exchanger cannot receive cash or other benefits (unless the Exchanger pays capital gain taxes on this money).
In any exchange the Exchanger must enter into the exchange transaction prior to the close of the relinquished property. The Exchanger and the Qualified Intermediary enter into an Exchange Agreement, which essentially requires that (a) the Qualified Intermediary acquires the relinquished property from the Exchanger and transfers it to the buyer by a direct deed from the Exchanger and, (b) the Qualified Intermediary acquires the replacement property from the seller and transfers it to the Exchanger by a direct deed from the seller. The cash or other proceeds from the relinquished property are assigned to the Qualified Intermediary and are held by the Qualified Intermediary in a separate, secure account. The exchange funds are used by the Qualified Intermediary to purchase the replacement property for the Exchanger.
Important Considerations for an Exchange
Exchanges must be completed within strict time limits with absolutely no extensions. The Exchanger has 45 days from the date the relinquished property closes to "Identify" potential replacement properties. This involves a written notification to the Qualified Intermediary listing the addresses or legal descriptions of the potential replacement properties. The purchase of the replacement property must be completed within 180 days after of the close of the relinquished property. After the 45 days has passed, the Exchanger may not change their Property Identification list and must purchase one or more of the listed replacement properties or the exchange fails!
To avoid the payment of capital gain taxes the Exchanger should follow three general rules:(a) purchase a replacement property that is the same or greater value as is to the relinquished property, (b) reinvest all of the exchange equity into the replacement property and, (c) obtain the same or greater debt on the replacement property as on the relinquished property. The Exchanger can offset the amount of debt obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.
In the case of real property exchanges, the Exchanger must sell property that is held for income or investment purposes and acquire replacement property that will be held for income or investment purposes. This is the "like kind" property test.
IRC Section 1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust, or beneficial interests or interests in a partnership.
The Exchanger is always advised to discuss the intended exchange with their legal or tax advisor.
The Role of the Qualified Intermediary
The use of a Qualified Intermediary, also known as an "Accommodator" or "Facilitator" is essential to completing an IRC 1031 Tax Deferred Exchange. There are many exchange companies that can act as a Qualified Intermediary and perform several vital functions in an exchange.
Acting as a Principal
The IRS stipulates that a reciprocal trade or actual exchange must take place in each IRC 1031 transaction. This means the Exchanger must assign to a Qualified Intermediary (1) their interest as seller of the relinquished property and (2) their interest as buyer of the replacement property. By becoming an actual party to the exchange, a reciprocal trade takes place even when there are three or more parties involved in an exchange transaction (i.e. when the Exchanger is purchasing the replacement property from someone other than the buyer of their relinquished property).
Holding Exchange Proceeds
If the Exchanger actually or constructively receives any of the proceeds from the sale of their relinquished property, those proceeds will be taxable as "boot". The Qualified Intermediary will hold the proceeds from the sale in a separate exchange account until the funds are used to purchase the replacement property.
Preparing Legal Documentation
Several legal documents are necessary in order to properly complete an exchange. The Qualified Intermediary will prepare an Exchange Agreement, two Assignment Agreements and Exchange Closing Instructions for each closer.
The Delayed Exchange/Starker Exchange
There is a common misconception that all tax-deferred exchanges are complicated and require all properties, relinquished and replacement, to close concurrently. Fortunately, the most common exchange variation, the Delayed Exchange (also referred to as a deferred or 'Starker' exchange, Starker v. U.S., 602 F.2d 1341), provides Exchangers with more flexibility and options in acquiring the replacement property than the simultaneous exchange. The delayed exchange begins when the Exchanger's first relinquished property is sold and is completed when the last replacement property is acquired within the prescribed exchange period. To provide the required notice to the relinquished property buyer(s) and the replacement property seller(s), the Purchase and Sale Contract for each property should include an "exchange cooperation clause".
The use of a Qualified Intermediary is the most common method used to complete a valid delayed exchange quickly and easily. The Qualified Intermediary is an independent party to the exchange transaction, who performs the function of creating the reciprocal trade of properties for the exchange, holds the exchange funds and supplies the necessary exchange documents, such as the Exchange Agreement, Assignments and Closing Instructions. The Exchanger assigns the rights in the Sale Contract for the relinquished property and in the Purchase Contract for the replacement property to the Qualified Intermediary, who essentially becomes the "seller" of the relinquished property and the "buyer" of the replacement property. To avoid actual or constructive receipt of the exchange funds by the Exchanger, the proceeds from the sale of the relinquished property are held by the Qualified Intermediary until they are needed for the acquisition of the replacement property. In both simultaneous and delayed exchanges in which a Qualified Intermediary is used to create the reciprocal exchange of properties, the IRS allows "direct deeding" of the relinquished property from the Exchanger to the buyer and of the replacement property from the seller to the Exchanger, thereby avoiding the necessity of the Qualified Intermediary holding title to any property (Revenue Procedure 90-34, 1990-1 C.B. 552). Direct deeding avoids the assessment of double state, county, or local documentary transfer taxes and any liability on the part of the Qualified Intermediary for environmental hazards that may exist on the property.
Additional Important Information to Know About 1031 Exchanges
The informed investor who chooses to relinquish their property by using the 1031 Tax Deferred Exchange should attempt to gain further knowledge of the various aspects available in the program.