Section 1031 Tax-Deferred Exchange Transactions
This article will explain some of the basic requirements involved in Section 1031 Tax-Deferred Exchange transactions, and is intended to give general information only. It is not intended to be an all-inclusive review of the provisions of Internal Revenue Code §1031 and does not constitute legal advice. Prior to entering into a Section 1031 Tax-Deferred Exchange transaction, accounting and legal professionals should be consulted.
The ultimate goal of any Section 1031 Tax-Deferred Exchange is the non-recognition of capital gain as to the property the taxpayer is selling (the Relinquished Property). The first threshold to be met is whether the particular property qualifies for exchange treatment, i.e., has the property been held by the taxpayer for productive use in a trade or business or held by the taxpayer for investment purposes, and not for personal residential use or other non-qualified use. A general rule of thumb as to how long property must be held to qualify for "investment purposes" is to use the length of time that would allow the taxable gain to be taxed as long term, as opposed to short term, capital gain.
Prior to the sale of the Relinquished Property, the taxpayer must evidence his or her intent to enter into a Section 1031 Tax-Deferred Exchange transaction. This is typically initially indicated by means of a "cooperation clause" in the sales contract. The following is an example of this type of clause:
"Seller, at any time prior to the Closing Date, may elect to effect a simultaneous or non-simultaneous tax-deferred exchange pursuant to Section 1031, and the regulations pertaining thereto, of the Internal Revenue Code of 1986, as amended. Buyer expressly agrees to cooperate with Seller in connection with any such exchange in any manner which shall not impose any additional cost or liability upon Buyer, including without limitation by executing any and all documents, including escrow instructions or agreements consenting to Seller's assignment of his rights and obligations hereunder to an exchange entity, which may be necessary to carry out such an exchange; provided, however, that Buyer shall not be required to take title to any property in order to accommodate Seller in effecting the exchange; and provided further, however, that Seller’s election to effect such an exchange shall not delay the Closing Date."
It is essential to document the intention to participate in a Section 1031 Tax-Deferred Exchange Transaction with a formal Exchange Agreement or similar agreement between the taxpayer and the Qualified Intermediary, whose role and function will be reviewed below. It is absolutely essential to accomplish the goal non-recognition of gain that the contract for the sale of the Relinquished Property be assigned to the Qualified Intermediary and that the Purchaser acknowledges the assignment by signing a Notice of Assignment form prior to settlement taking place.
Upon the sale of the Relinquished Property, the net sale proceeds will be payable to the Qualified Intermediary. The primary function of the Qualified Intermediary is to serve as the requisite qualified and disinterested third party for purposes of receiving, holding and subsequently disbursing the sale proceeds in a manner that permits the taxpayer to achieve the desired non-recognition of gain on the sale of the interest in the Relinquished Property. As a disinterested party, receipt of the sale proceeds by the Qualified Intermediary prevents the taxpayer from having either direct receipt of the sale proceeds or constructive receipt (e.g., if the taxpayer’s attorney received the proceeds on his or her behalf, it is the same as if the taxpayer had received the funds), both of which would result in recognition of the gain on the sale of the Relinquished Property. Receipt of the sale proceeds by the Qualified Intermediary has to occur, regardless of whether there will be twenty-four hours between the sale and purchase transactions, or whether the Qualified Intermediary will hold the proceeds for several weeks or months, in which instance the Qualified Intermediary will typically deposit the funds in an interest-bearing account for the ultimate benefit of the taxpayer.
Once the sale of the Relinquished Property occurs (and not before), the taxpayer has until midnight of the date that is forty-five (45) days after the date on which the transfer of title of the Relinquished Property occurs to identify a Replacement Property. This identification should be in writing and directed to the Qualified Intermediary, and the property should be sufficiently identified so that someone not involved in the transaction can ascertain its location. The identification may be hand-delivered, mailed, faxed or sent by e-mail.
There are numerous nuances of identifying Replacement Property in terms of how many properties the taxpayer may identify and the values of those properties. Generally, the taxpayer may identify up to three (3) properties as potential Replacement Properties, regardless of the aggregate fair market value of the three (3) properties. The taxpayer may revoke an identification and substitute another property if the taxpayer is within the forty-five (45) days identification period. If the taxpayer identifies more than three (3) properties without first revoking a prior identification, the taxpayer is limited by a maximum aggregate fair market value of 200% of the fair market value of the Relinquished Property. Failure to properly identify the Replacement Property in a timely manner will result in recognition of the gain from the sale of the Relinquished Property.
Under the Regulations, the taxpayer also has until the earlier of (a) one hundred eighty (180) days from the date of the transfer of title of the Relinquished Property (not the date of identification), or (b) the date on which the taxpayer’s federal income tax return is due for the tax year in which the Relinquished Property transaction occurs, to complete the acquisition of the Replacement Property. These timing rules (for both identification and completion of the transaction) are strict and absolute, and there are no exceptions for the deadline falling on weekends, holidays, etc.
It is also absolutely essential that the contract for the purchase of the Replacement Property be assigned to the Qualified Intermediary and that the Seller of that property acknowledges the assignment by signing a Notice of Assignment form prior to settlement taking place. Again, a cooperation clause such as the following is useful in the purchase contract:
"Buyer, at any time prior to the Closing Date, may elect to effect a simultaneous or non-simultaneous tax-deferred exchange pursuant to Section 1031, and the regulations pertaining thereto, of the Internal Revenue Code of 1986, as amended. Seller expressly agrees to cooperate with Buyer in connection with any such exchange in any manner which shall not impose any additional cost or liability upon Seller, including without limitation by executing any and all documents, including escrow instructions or agreements consenting to Buyer’s assignment of his rights and obligations hereunder to an exchange entity, which may be necessary to carry out such an exchange; provided, however, that Seller shall not be required to take title to any property in order to accommodate Buyer in effecting the exchange; and provided further, however, that Buyer’s election to effect such an exchange shall not delay the Closing Date."
It is further absolutely essential to a successful non-reverse exchange transaction that all aspects of the transactions occur in the proper sequence, as follows, and that each step of the sequence is fully documented:
1. The taxpayer enters into the Exchange Agreement;
2. The taxpayer assigns the Relinquished Property contract to the Qualified Intermediary;
3. The Purchaser of the Relinquished Property acknowledges the assignment;
4. Settlement occurs on the Relinquished Property;
5. The proceeds are forwarded directly to the Qualified Intermediary;
6. The taxpayer identifies his or her Replacement Property or Properties in writing to the Qualified Intermediary;
7. The taxpayer assigns the Replacement Property contract to the Qualified Intermediary;
8. The Seller of the Replacement Property acknowledges the assignment;
9. The Qualified Intermediary provides the net escrowed proceeds to the taxpayer’s closing attorney for use toward the acquisition of the Replacement Property; and
10. Settlement occurs on the Replacement Property.
Once the taxpayer is involved in an exchange transaction, there are restrictions on when the funds can be released, even if the taxpayer decides at the last minute not to participate in an exchange. These rules are also applicable if the taxpayer does not use all of the funds that the Qualified Intermediary holds for the purchase of the Replacement Property.
Please feel free to contact our firm if you need assistance with a Section 1031 Tax-Deferred Exchange transaction.
Copyright © 2003
John W. Anderson
