Section 1031 of the Internal Revenue Code defines the tax-deferred exchange as an excellent opportunity for taxpayers to build wealth and save on taxes. By completing an exchange, taxpayers can dispose of investment or business assets, acquire replacement property, and defer taxes that would otherwise be due upon sale. To qualify for tax deferral, the exchanger must purchase “like kind” replacement property that will be held for investment or used productively in a trade or business. The replacement property must also be of equal or greater value and have the same or greater debt. Cash equity cannot be replaced with additional debt, and the exchanger may not receive cash or benefits from the sale proceeds during the exchange. As of January 1, 2018, Section 1031 applies only to real property assets and not to personal property, stock in trade, inventory, or property held for sale. To execute an exchange, multiple parties are involved, including the exchanger, the buyer of the relinquished property, the seller of the replacement property, and a Qualified Intermediary.
The 1031 Exchange Process
Timing is crucial in a tax-deferred exchange, as specific actions must be taken in sequence and within strict time limits. The following steps must be completed: Before the transfer of the Relinquished Property, the Exchanger, acting as Qualified Intermediary, must sign an Exchange Agreement. This agreement obligates the Qualified Intermediary to acquire the Relinquished Property from the Exchanger and transfer it to the buyer, while also acquiring the Replacement Property from the seller and transferring it to the Exchanger. Before the transfer of the Relinquished Property, the Exchanger must assign their rights under the sale contract to the Qualified Intermediary and provide notice of this assignment to the buyer. At closing, the net proceeds from the Relinquished Property sale, known as exchange funds, are paid directly to the Qualified Intermediary to be held in a separate account for the benefit of the Exchanger until used to purchase Replacement Property.
Within 45 calendar days from the transfer of the Relinquished Property, the Exchanger must identify potential Replacement Properties. The identification must be specific, unambiguous, in writing, signed by the Exchanger, and delivered to the Qualified Intermediary or another permitted party. The list of identified Replacement Properties cannot be changed after the 45th day, and if no property is identified, the exchange funds will be returned to the Exchanger. Before the transfer of the Replacement Property, the Exchanger must assign their rights under the purchase contract to the Qualified Intermediary and provide notice of this assignment to the seller. The Exchanger must authorize the Qualified Intermediary to wire funds directly to the seller or closing agent for the purchase of the Replacement Property. The seller must transfer the title directly to the Exchanger to complete the exchange. The acquisition of the Replacement Property must be completed by the earlier of 180 days after the transfer of the first Relinquished Property or the due date (including extensions) for filing the Exchanger’s tax return. Any unspent exchange funds will be returned to the Exchanger at the termination of the exchange.
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