IRC (Internal Revenue Code) section 1031 gave rise to what is commonly referred to as a 1031 exchange. A 1031 exchange is a vehicle for deferring taxes, not eliminating them. The benefits of deferring taxes are both the time value of money and the belief that the taxpayer will be in a lower tax bracket down the road when the gain is ultimately realized. IRC 1031 (a)(1) provides that 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. Although 1031 exchanges can be used for personal property, this discussion is limited to real property exchanges.
Advanced planning to properly complete a 1031 exchange requires hiring a Qualified Intermediary (QI) that will hold the funds from the property being exchanged and later provide the funds to the transaction when the taxpayer (exchangor) acquires the replacement property or properties. A QI is necessary to avoid constructive receipt of the proceeds triggering taxes owed, but it is imperative to choose wisely. A lot of money has been lost by the selection of dishonest or reckless QIs from theft, commingling, or reckless investing of the funds being held. The QI should never be allowed the benefit of any interest on the held funds. QIs, including very large ones, have gone out of business investing in auction rate securities in an effort to maximizes the QI’s income leading to losses of a portion or sometimes all of the funds they were holding. So size doesn’t equal safety, and a low exchange fee with the QI receiving the income from held funds is a bad idea.
There is no federal QI licensing and only some states have licensing requirements. Due diligence is imperative in investigating the QI’s qualifications including, but not limited to, their financial strength, length of time in business/experience; education/knowledge of the individuals representing the QI (look for CE designation and experienced exchange attorneys); BBB rating/reputation; whether a member of Federation of Exchange Accommodators; and their business practices including verifying they segregate all held funds in separate FDIC insured accounts with all interest going to the exchangor, not the QI. Requiring the QI to have additional insurance, a fidelity bond, E&O coverage and perhaps if the QI is affiliated with an underwriter, an underwriter’s indemnity for all of the funds, or that amount exceeding the FDIC limit. are all prudent strategies.
The exchangor has 45 days from the closing of the sale of the relinquished property (midnight on the 45th day) to designate in a signed, written document the replacement property, or properties, and has 180 days to close on the replacement property or properties. The exchangor during the 45 days may designate either up to 3 properties or any number of properties not to exceed 200% of the value of the relinquished property. Such property must be in the United States. The exchangor isn’t required to close on all the properties designated so it gives the exchangor some flexibility.
In Part 2, I will discuss the deferred taxes involved in a little more detail; the concept of boot; defining “like kind”; and the basics of reverse and parking exchanges.
In Part 3, I will discuss vacation homes and strategies involving the conversion of investment property into primary residences thereby using an exchange along with IRC code section 121 (exclusion of 250/500k of gain on primary residence); exchange expenses; allowable and unallowable closing costs; and a simple summary of the steps from beginning to end.