Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do's and don'ts, and several gray areas of which taxpayers should be aware. For the taxable gain to be deferred, specific and vital requirements must be satisfied:
- The exchange must be equal or up in value
- The exchange must follow the time limit and identification requirements
- The taxpayer must hold the properties for business or investment purposes
- The taxpayer must exchange properties
- Properties must be "like-kind"
- There must be no constructive or actual receipt of exchange funds:
- It is a violation if the taxpayer or an agent for the taxpayer receives exchange funds or the taxpayer is directly or indirectly able to control the exchange funds during the exchange period
Receipt of Funds
Internal Revenue Code Section 1031 states 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 for productive use in a trade or business or for investment." 1031 Exchange s are a time-proven tax strategy that encourages the continuity of business investment. The benefits of 1031 like-kind exchanges are in all areas of commerce. Like-kind exchanges are a tax deferral, NOT a tax avoidance. By deferring the taxes, property owners can reinvest that money back into the economy by applying the money towards a productive property, creating jobs for entry-level to top executive employees, housing opportunities, and more.
A safe harbor provision in Section 1031 ensures the tax is deferred, not avoided is the regulation prohibiting the exchanger (or any agent) of the taxpayer to receive or control the funds from the sale of a property in an exchange. Because of this provision, the use of a qualified intermediary (QI) is required for a 1031 exchange to take place.
Choosing a 1031 Exchange Qualified Intermediary (QI)
In a forward exchange, the taxpayer and their chosen qualified intermediary (QI) set up and enter into what is called an “exchange agreement.” The exchange agreement is where the exchanger assigns their rights to sell the relinquished property to the QI. The QI can then sell the property the taxpayer wishes to exchange and hold the proceeds from the relinquished property sale in an exchange account. The taxpayer does not receive the funds, and their exchange is still valid. These funds are kept in a secure account and will only be used to purchase the property the taxpayer has identified as a replacement. Once a replacement property is selected, the rights to acquire that property are assigned to the QI. The QI sends the funds held in a taxpayer's exchange account directly to the closing to purchase the replacement property, ensuring a smooth and valid 1031 exchange.
1031 Exchange Pitfalls to Avoid
The identification period of a 1031 exchange refers to the first 45-days when a taxpayer identifies property they would like to acquire as a replacement to their relinquished property. It is common for a taxpayer to identify more than one potential replacement property, but only purchase one. If there are excess funds in the exchange account, the QI can return them once an exchange is complete. If the taxpayer has identified more than one potential replacement property the excess funds must remain in the exchange account until the end of the 180-day exchange period. Receiving funds before the end of the exchange period could jeopardize the entire exchange.
To prevent this situation, Accruit requires the taxpayer to indicate how many properties they intend to acquire. Once those transactions are complete, the funds can be returned.
Early Release of Funds
If a taxpayer decides not to move forward with an exchange, they must acknowledge to their QI that they understand they will pay all applicable taxes on the gain. Even so, exchange facilitators are only permitted to disburse funds at particular times for particular reasons. The only time someone can terminate an exchange early is at the end of the 45-day identification period. If the taxpayer has not identified a single property by 45 days, they can close their exchange, and the funds can be disbursed. If the taxpayer has identified any property, funds must be held until the transaction is complete or at the end of the 180-day exchange period. Suppose an exchange facilitator is found to be deviating from the rules. In that case, failure to comply with regulation could jeopardize any of this taxpayer's previous exchanges and any other exchanges facilitated by the company.
1031 Exchange Timeline
"Can I start a 1031 exchange after I've sold my property?” or "I just closed on my property; can I still do an exchange?" There are a few variations to this question, but ultimately the answer is always the same. Once you've sold and closed on a property, it is no longer eligible for exchange. The taxpayer cannot take actual possession or control the net proceeds from the sale of a relinquished property in a 1031 exchange. An exchanger must contact a QI before selling their property. If you find yourself short on time or at the closing table, don't lose hope with processing an exchange. With Accruit's patented software, Exchange Manager Pro℠, we can get you set up for a rush exchange in under an hour.