In our last two blogs we’ve been discussing different aspects of a Tax-Deferred Exchange – a technique available to defer taxes and maximize the funds available for reinvestment upon the sale of an investment property.
Because of the complexity of the issues, we’ve broken it down into three different blogs. The first was on the technique’s limitations, the second was on setting up a trust for the exchange. This week we’ll be discussing practical considerations when setting up at Tax-Deferred Exchange. Here are seven things we believe you need to keep in mind when considering this approach.
1: The Buyer must be aware of and acknowledge the agreement
With reference to the Relinquished Property the following provision must be included in the contract with the buyer:
“Buyer acknowledges it is the intent of Seller to complete a tax deferred exchanged under IRC Section 1031 which will not delay the close of the purchase transaction or cause additional expense to the Buyer. Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary of the Seller’s choice for the purpose of completing such an exchange. Buyer agrees to cooperate with Seller and Qualified Intermediary in a manner necessary to complete the exchange.”
2: The Seller of the Replacement Property must be aware of and acknowledge the agreement
With reference to the Replacement Property the following provision must be included in the contract with the seller:
“Buyer is acquiring the Property to complete a Tax Free Exchange under Section 1031 of the Internal Revenue Code, and pursuant to a Tax-Deferred Exchange Trust Agreement with a Qualified Intermediary nominated to serve as Trustee with full powers to complete the exchange. Settlement on the Property will be coordinated with the Trustee, who will instruct the Seller as to the manner by which title to the Property shall be conveyed to Buyer. There will be no additional expense to Seller as a result of the Exchange, however Seller agrees to cooperate with Buyer and Qualified Intermediary to allow completion of the exchange.”
3: The Replacement Property must be designated within a very specific amount of time
The Replacement Property must be identified and designated to the Qualified Intermediary within 45 days of settlement on the sale of the Relinquished Property. You do not have to wait until the Relinquished Property has sold before finding and designating the Replacement Property, but the second property may not go to settlement before the first property has been sold and settled.
4: Replacement properties cannot be a personal residence
Do not try to exchange an investment property for a “personal residence.” This is also true for a second home. However, a resort property used for rental purposes, or held for its investment potential, may qualify for an exchange.
5: The exchange must be of equal value to avoid taxable gain
Remember, the essence of the exchange is that the taxpayer receives “property for property” and never realizes a taxable gain. If the taxpayer ever receives “money for property” the opportunity for the exchange is lost as the taxpayer will have realized a taxable gain.
Provided that the Qualified Intermediary and Tax-Deferred Exchange Trust is properly used, the Taxpayer will receive “property for property” and as a result will not have realized a gain. It is vital that a properly crafted Trust/Escrow Agreement be used with an independent Qualified Intermediary as the IRS prohibits the taxpayer’s attorney or a related party from holding funds required to complete the transaction.
6: There are no extensions!
There are no extensions permitted for either the 45-day Identification Period or 180-day Exchange Period rules. If you go over those limits no tax is deferred, so start looking for the new property or properties as soon as the decision is made to exchange the Relinquished Property. You may find the Replacement Property and even contract for that property prior to settlement on the Relinquished Property, however you must settle on the properties in the correct order. It is the Qualified Intermediary as Trustee who acquires the Replacement Property.
7: Consider your “debt for debt” on the properties
It is permissible to realize some cash from the exchange process, but such funds will probably be taxable. Remember that if your Relinquished Property is encumbered you must have at least as much debt on the Replacement Property or it will be treated as if it were cash.
As a result of very complex Internal Revenue regulations it is highly recommended that you consult with a Certified Public Accountant in order to determine your actual tax savings and/or any potential for the realization of “boot” or other taxable income in a Section 1031 Tax Free Exchange.
This article is intended only for the purpose of providing general information and does not constitute legal advice. By providing this information we are not establishing an attorney-client relationship and nothing contained in this article should be construed to necessarily be applicable to your unique situation. You should always engage the services of an attorney to determine which, if any, legal solutions are right for you.
1031 Tax-Deferred Exchange: 7 Practical Considerations
In our last two blogs we’ve been discussing different aspects of a Tax-Deferred Exchange – a technique available to defer taxes and maximize the funds available for reinvestment upon the sale of an investment property.
Because of the complexity of the issues, we’ve broken it down into three different blogs. The first was on the technique’s limitations, the second was on setting up a trust for the exchange. This week we’ll be discussing practical considerations when setting up at Tax-Deferred Exchange. Here are seven things we believe you need to keep in mind when considering this approach.
1: The Buyer must be aware of and acknowledge the agreement
With reference to the Relinquished Property the following provision must be included in the contract with the buyer:
“Buyer acknowledges it is the intent of Seller to complete a tax deferred exchanged under IRC Section 1031 which will not delay the close of the purchase transaction or cause additional expense to the Buyer. Seller’s rights under the purchase and sale agreement may be assigned to a Qualified Intermediary of the Seller’s choice for the purpose of completing such an exchange. Buyer agrees to cooperate with Seller and Qualified Intermediary in a manner necessary to complete the exchange.”
2: The Seller of the Replacement Property must be aware of and acknowledge the agreement
With reference to the Replacement Property the following provision must be included in the contract with the seller:
“Buyer is acquiring the Property to complete a Tax Free Exchange under Section 1031 of the Internal Revenue Code, and pursuant to a Tax-Deferred Exchange Trust Agreement with a Qualified Intermediary nominated to serve as Trustee with full powers to complete the exchange. Settlement on the Property will be coordinated with the Trustee, who will instruct the Seller as to the manner by which title to the Property shall be conveyed to Buyer. There will be no additional expense to Seller as a result of the Exchange, however Seller agrees to cooperate with Buyer and Qualified Intermediary to allow completion of the exchange.”
3: The Replacement Property must be designated within a very specific amount of time
The Replacement Property must be identified and designated to the Qualified Intermediary within 45 days of settlement on the sale of the Relinquished Property. You do not have to wait until the Relinquished Property has sold before finding and designating the Replacement Property, but the second property may not go to settlement before the first property has been sold and settled.
4: Replacement properties cannot be a personal residence
Do not try to exchange an investment property for a “personal residence.” This is also true for a second home. However, a resort property used for rental purposes, or held for its investment potential, may qualify for an exchange.
5: The exchange must be of equal value to avoid taxable gain
Remember, the essence of the exchange is that the taxpayer receives “property for property” and never realizes a taxable gain. If the taxpayer ever receives “money for property” the opportunity for the exchange is lost as the taxpayer will have realized a taxable gain.
Provided that the Qualified Intermediary and Tax-Deferred Exchange Trust is properly used, the Taxpayer will receive “property for property” and as a result will not have realized a gain. It is vital that a properly crafted Trust/Escrow Agreement be used with an independent Qualified Intermediary as the IRS prohibits the taxpayer’s attorney or a related party from holding funds required to complete the transaction.
6: There are no extensions!
There are no extensions permitted for either the 45-day Identification Period or 180-day Exchange Period rules. If you go over those limits no tax is deferred, so start looking for the new property or properties as soon as the decision is made to exchange the Relinquished Property. You may find the Replacement Property and even contract for that property prior to settlement on the Relinquished Property, however you must settle on the properties in the correct order. It is the Qualified Intermediary as Trustee who acquires the Replacement Property.
7: Consider your “debt for debt” on the properties
It is permissible to realize some cash from the exchange process, but such funds will probably be taxable. Remember that if your Relinquished Property is encumbered you must have at least as much debt on the Replacement Property or it will be treated as if it were cash.
As a result of very complex Internal Revenue regulations it is highly recommended that you consult with a Certified Public Accountant in order to determine your actual tax savings and/or any potential for the realization of “boot” or other taxable income in a Section 1031 Tax Free Exchange.
This article is intended only for the purpose of providing general information and does not constitute legal advice. By providing this information we are not establishing an attorney-client relationship and nothing contained in this article should be construed to necessarily be applicable to your unique situation. You should always engage the services of an attorney to determine which, if any, legal solutions are right for you.
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