Basics of a Section 1031 Tax-Deferred Exchange Transaction

The ultimate goal of any Section 1031 Tax-Deferred Exchange Transaction is to avoid capital gains taxes on the sale of the taxpayer's real property (the Relinquished Property). This short article explains some of the technical requirements involved in these transactions.

First, both the Relinquished Property to be sold and the property to be acquired (the Replacement Property) must qualify for exchange treatment. This means that the Relinquished Property has been held, and the Replacement Property will be held, by the taxpayer for productive use in a trade or business or for investment purposes, and not for personal residential use or other non-qualified use.

Second, upon the sale of the Relinquished Property, the sale proceeds are paid to a "Qualified Intermediary." The Qualified Intermediary's primary function is to receive, hold and subsequently disburse the sale proceeds in a manner that permits the taxpayer to avoid recognition of gain on the sale of its Relinquished Property. Receipt of the sale proceeds by the Qualified Intermediary prevents the taxpayer from having received the proceeds directly or constructively (e.g., if the taxpayer's attorney receives the proceeds, it is the same as if the taxpayer had received the funds), either of which would result in recognition of the gain on the sale of the Relinquished Property. Payment of the sale proceeds to the Qualified Intermediary must occur, regardless of the length of time between the sale of the Relinquished Property and the purchase of the Replacement Property.

Third, once 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 occurs to identify its Replacement Property. This identification must be in writing, directed to the Qualified Intermediary, and must identify the potential Replacement Property or Properties sufficiently so that someone not involved in the transaction can ascertain the location or locations of the Replacement Property or Properties. The identification typically may be hand-delivered, mailed, faxed or sent by e-mail, and must be signed by the taxpayer.

Fourth, although there are numerous nuances in how many Replacement 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 identified property and substitute another property if the revocation and substitution occurs within the forty-five (45) day identification period. If the taxpayer identifies more than three (3) properties, 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 or Properties in a timely manner will result in recognition of the gain from the sale of the Relinquished Property.

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 or state or federal holidays. Failure to acquire an identified Replacement Property or Properties within the foregoing time limitations will result in recognition of the gain from the sale of the Relinquished Property.

Prior to sale of the Relinquished Property, the taxpayer and the Qualified Intermediary will sign an Exchange Agreement which sets out the "relationship" between the taxpayer as the seller of the Relinquished Property and the duties of the Qualified Intermediary and establishes the Qualified Intermediary's fees. This agreement also serves as written evidence of the taxpayer's intent to participate in an exchange transaction.

In addition to the requirements just discussed, there are a number of absolutely essential steps to accomplish the goal of non-recognition of capital gain on the sale of the Relinquished Property. First, the contract or purchase agreement for sale must be assigned to the Qualified Intermediary and the Purchaser must acknowledge the assignment by signing a Notice of Assignment form prior to settlement taking place. Second, the contract or purchase agreement for the taxpayer's purchase of the Replacement Property must also be assigned to the Qualified Intermediary and the seller of that property must acknowledge the assignment by signing a Notice of Assignment form prior to settlement taking place.

In summary, the following steps are essential to a successful tax-deferred exchange transaction and must occur in the proper sequence, as follows:

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 to and received by the Qualified Intermediary;
6. The taxpayer identifies its Replacement Property or Properties in writing to the Qualified Intermediary;
7. The taxpayer enters into a Contract to purchase the Replacement Property (which may occur at an earlier date) and 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 escrowed proceeds, less the Qualified Intermediary Fees and Costs, to the taxpayer's closing attorney for use toward the acquisition of the Replacement Property; and
10. Settlement occurs on the Replacement Property.

This brief summary covers only the "basics" of a Section 1031 Tax-Deferred Exchange Transaction, but if these basic steps are followed and properly documented, the taxpayer should be successful in achieving the goal of non-recognition of gain on the disposition of the Relinquished Property. Consultation with an expert in tax planning is highly recommended.