1031 Exchange Qualified Intermediary Services 1031 Exchange Explained 1031 refers to a section of the Internal Revenue Code which provides an investor with the opportunity to defer capital gains taxes from the sale of an investment property by reinvesting the proceeds from the sale into another investment property. Section 1031 specifically provides that “[n]o 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 a like kind which is to be held either for productive use in a trade or business or for investment.” The “Exchange” In a 1031 Exchange, the property being sold is referred to as the “Relinquished Property” and the property being acquired is referred to as the “Replacement Property”. As applied to Section 1031, the Relinquished Property is being “exchanged” for the Replacement Property and capital gains taxes can therefore be deferred for the sale of the Relinquished Property. Deferring taxes allows the investor to maximize the return on their investment by preserving equity and increasing cash flow by purchasing a larger or more valuable property. Productive use in a trade or business or for investment To clarify the scope of Section 1031, the IRS expounded on the definition of property held for productive use in a trade or business in IRS Revenue Procedure 2008-16. This revenue procedure provides taxpayers with a safe harbor under which a dwelling unit will qualify as property held for productive use in a trade or business or for investment under Section 1031 even though a taxpayer occasionally uses the dwelling unit for personal purposes. According to the IRS, a dwelling unit is defined as real property improved with a house, apartment, condominium, or similar improvement that provides basic living accommodations including sleeping space, bathroom and cooking facilities. IRS Revenue Procedure 2008-16 provides that the IRS will not challenge whether a dwelling unit qualifies under Section 1031 as property held for productive use in a trade or business or for investment if the Relinquished property qualifies. A dwelling unit that a taxpayer intends to be Relinquished Property qualifies as property held for productive use in a trade or business or for investment if: 1. The dwelling unit is owned by the taxpayer for at least 24 months immediately before the exchange (the “qualifying use period”); and 2. Within the qualifying use period, in each of the two 12-month periods immediately preceding the exchange, a. The taxpayer rents the dwelling unit to another person or persons at a fair rental for 14 days or more; and b. The period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at a fair rental. For this purpose, the first 12-month period immediately preceding the exchange ends on the day before the exchange takes place(and begins 12 months prior to that day) and the second 12-month period ends on the day before the first 12-month period begins (and begins 12 months prior to that day). Like kind property The IRS defines like kind property as follows: Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land. Real property and personal property can both qualify as exchange properties under Section1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks. Finally, certain types of property are specifically excluded from Section 1031 treatment. Section1031 does not apply to exchanges of: Inventory or stock in trade Stocks, bonds, or notes Other securities or debt Partnership interests Certificates of trust Time limits The IRS provides the following information regarding time limits: While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters. The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient. Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified. The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above. https://www.irs.gov/uac/Like-Kind-Exchanges-Under-IRC-Code-Section-1031 https://www.irs.gov/pub/irs-pdf/f8824.pdf Qualified Intermediary Taxpayers must use a Qualified Intermediary (QI) to qualify for a 1031 tax deferred exchange of like kind property. The QI’s role in the exchange is to serve as an accommodator and facilitate the exchange transaction. The QI enters into an exchange agreement with the taxpayer whereby the QI agrees to hold the proceeds from the sale of the Relinquished Property in trust, transfers the Relinquished Property to the buyer and, at the taxpayer’s direction, wires the funds held in trust to the closing agent for the Replacement Property. By using a QI, the taxpayer avoids actual or constructive receipt of the sale proceeds from the Relinquished Property thereby avoiding a taxable event. A QI cannot be a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction. The Thompson & Fernald team has provided estate planning services to clients in the Clearwater, Florida area for some thirty years. Call 727 447-2290 or contact us to arrange a consultation.