1031 Exchanges - How They Work

What is a 1031 Exchange?

Under normal circumstances, when you sell a property you have to pay tax on the gain. Gain is caused by taking depreciation deductions for tax purposes or by the property appreciating in value during its ownership.

A Section 1031 tax deferred exchange, named for the Internal Revenue Code Section it refers to, allows an exception to the capital gains tax. When you sell your business or investment real estate, replace it with a different business or investment real estate, and complete an exchange, you can defer payment of the capital gains tax normally required on these sales.

If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 Exchange provides greater proceeds for your next investment - more than you could gain through the re-investment of after-tax proceeds.

A 1031 Exchange is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain.

Understanding an Exchange

All relinquished (old) and replacement (new) property must be vacant land, rental property or property used for trade, business or investment.

If the properties meet the following requirements, you may exchange any real estate for any other type of real estate.

You cannot have actual or constructive control of any of the proceeds received from the sale of the old property. By law, all money is held by a Qualified Intermediary (also referred to as an Accommodator or Facilitator). You cannot have an associate or employee, your attorney, broker or CPA hold the proceeds, nor can you leave the proceeds in escrow until the second property is purchased.
You have 45 days from the date of closing on the old property to identify a list of properties from which you will purchase the new property.
From the date of closing, you have 180 days to close on one or more of the properties from your 45-day list.
The titleholder on the old property must be the same titleholder on the new property.
You must reinvest all cash proceeds from the sale, and purchase a new property or properties of equal or greater value, in order to avoid taxation on the gains.

Selecting a Qualified Intermediary

A Qualified Intermediary (QI) is one of the most important aspects of an exchange. A QI is required by federal tax law and provides a safe harbor for the taxpayer. There are no federal or state laws governing who can be a QI - only laws concerning who cannot serve as your QI (i.e. your attorney, banker, CPA, employee or any family member). There are also no laws regulating training or licensing. However, with thorough research, you can choose your QI with confidence.

Investigate their experience, background and credentials. They should be CPAs or attorneys with extensive real estate and 1031 Exchange knowledge and expertise.
Confirm they guarantee their exchanges without additional charges. Do they require you to release your right to sue, or will they pay the penalty if they make a mistake?
Find out who keeps the interest on the funds they hold. Some QIs will quote low or flat fees and keep the interest earned from the exchange funds that they hold.
Ensure that your QI is accessible and available to meet with you face-to-face. Can you reach them by phone anytime to answer all questions and eliminate your concerns?
Verify they are active members of the Federation of Exchange Accommodators (FEA), the only national organization for qualified intermediaries.
Verify they hold the "Certified Exchange Specialist" designation, the only certification for 1031 Exchange consultants.
Confirm that they carry an independent bond by an insurance company (this is different than title insurance bonding) and that they have Errors and Omissions coverage for your protection.

Excerpt from Investment Exchange Group brochure on 1031 Exchanges.

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