The 1031 Exchange is a commonly used tax benefit in real estate investments. In a nutshell, a 1031 Exchange allows real estate investors to delay paying capital gains taxes on the sale of an investment property when they roll the proceeds of that sale into a new investment property of like kind that is of equal or greater value. Unless you are a tax advisor, you should use caution when discussing the 1031 with investors so as not to give unsolicited tax advice – but it is important that you can answer basic questions about what it is and how it works.

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WHO ARE THE KEY PLAYERS IN THE TRANSACTION?

A 1031 involves an investor who sells “Relinquished Property” and rolls the proceeds into buying the “Replacement Property”. The transfer of proceeds from the Relinquished Property to the Replacement Property is not direct. In the middle of this transaction is a “Qualified Intermediary,” whose role is to prevent the investor from having actual or constructive receipt of the proceeds.

If the IRS finds that the investor had actual or constructive receipt of the proceeds, the transaction will not be protected by the “Safe Harbor” of the IRS regulations, meaning the proceeds could be deemed taxable income. A person who has acted as the investor’s employee, attorney, accountant, investment banker/broker, or real estate agent/broker within two years of the transfer of the Relinquished Property is specifically disqualified to be a Qualified Intermediary.

HOW DOES THE PROCESS WORK?

  • This process begins with the investor engaging the Qualified Intermediary. Prior to the transfer of the Relinquished Property, the investor enters into an agreement with the Qualified Intermediary (1)to acquire the relinquished property from the investor and transfer to the buyer, and (2) to acquire the replacement property from the seller and transfer it to the investor. The Qualified Intermediary never has to appear in the chain of title because the Investor assigns his rights to the Qualified Intermediary. Notice of the assignment must be given to the buyer of the Relinquished Property
  • At the closing of the investor’s sale of the Relinquished Property, the net proceeds are deposited into a separate bank account of the Qualified Intermediary and will be held in that account until the closing on the Replacement Property.
  • This date of transfer of the Relinquished Property also starts the clock for the investor to find the Replacement Property. The investor has 45 calendar days to declare, with certain specificity, what property is the Replacement Property. This is a strict deadline and includes holidays and weekends.
  • The investor then must acquire the Replacement Property within the earlier of (a) 180 days from the date of transfer of the Relinquished Property or (b) the date the investor must file the tax return (including extensions) for the year of the transfer of the Relinquished Property. This means that the entire process takes up to 180 days. Only congress can extend the deadline – and did so recently in light of the COVID-19 pandemic.
  • The process ends with the investor pocketing no actual money and walking away with just the Replacement Property.

WHAT DOES A TITLE AGENT NEED TO KNOW SPECIFICALLY ABOUT 1031s?

  • An investor can purchase a Replacement Property prior to transferring the Relinquished Property in what is called a “Reverse Exchange.”
  • In the transfer of the Relinquished Property, some line items on the seller/investor side of the HUD could jeopardize the tax consequences of the entire exchange. Because these line items paid for by the investor are taken from the proceeds of the sale, the IRS may consider this to be a constructive receipt of the proceeds. For example, title insurance and the Qualified Intermediary fees are allowed with no consequence. Yet, certain loan charges and prorated rents and deposits paid on behalf of the seller are not protected. This is why the investor/sellers in a 1031 Exchange will bring separate checks to pay for the pro-rated rents and deposits.
  • Multiple properties can replace the Relinquished Property, but they must fall into one of the specific options provided for in the tax code.
  • A former principal residence could qualify as a Relinquished Property under narrow circumstances, such as where it has been converted to a rental property for a specified period.
  • There are also narrow circumstances under which a vacation home could qualify as a Relinquished Property. Some requirements include the length of time that the investor has owned the property, how many days the property has been rented out for fair market value, and how may days the investor used the property for personal purposes.

*As with any tax inquiries, leave the specifics of particular situations to the tax experts