Exploring the Working Mechanics of the 1031 Exchange Agreement

Definition of a 1031 Exchange Agreement

A 1031 Exchange Agreement is a legally binding contract entered into between a taxpayer and a qualified intermediary (QI) who is designated as an exchange facilitator. The entire structure of the real estate transaction is set through the execution of an agreement that will outline the conditions under which the sale and purchase of the relinquished property and replacement property will occur. The QI, as an independent third party, will hold all or a portion of the sales proceeds from the relinquished property for the term of the exchange. The QI is responsible for the logistics of the 1031 exchange in the role of holding funds, preparing documentation and exchanging properties. The QI is crucial to the process and must be independent of the taxpayer and may not be considered a related party to the TP. Specifically, the QI is not to be considered related if it is incorporated or based in a different State from the taxpayer and if they are not the attorney , accountant, or employee and if etc. The terminology used in a 1031 Exchange Agreement is very specific and has different meanings than everyday language. Despite its name, it is more accurately known as a like-kind exchange or a Salvador Dali exchange. It is called a 1031 Exchange because of Section 1031 of the IRS Tax Code which gives the incentive to exchange.
Both the 1031 Exchange Agreement and the Qualified Intermediary Agreement as both need to accompany a 1031 exchange. If the 1031 Exchange Agreement is executed first, the taxpayer can name themselves as the qualified intermediary. The exchange is only available for properties that are held for productive use in a trade or business or for investment purposes. Real estate property owned by an individual does not qualify as "good since it is not tangible property," therefore any intent to sell real estate properties needs to be specified in the 1031 Exchange Agreement.

Advantages of 1031 Exchange

A property owner, large or small, can benefit significantly from the tax planning opportunity provided by the 1031 Exchange. A properly implemented 1031 Exchange can save a taxpayer significant amounts of capital gains tax, and subsequently provide opportunities for building long-term wealth through real estate investments. Taxpayers who complete a 1031 Exchange are permitted to defer the payment of capital gains taxes that would otherwise be due when they dispose of their real property holdings. The capital gains taxes are deferred until the taxpayer disposes of the replacement property, and the payment of capital gains taxes may be further delayed by coming into compliance with the section 121 principal residence exclusion or by utilizing another deferred exchange. Thus, the actual payment of the capital gains taxes may be deferred for many years. In addition to tax deferral, a 1031 Exchange can benefit a taxpayer in the following ways: Taxpayers may be able to obtain credit of state taxes paid on California property when the replacement property is located in another state. Taxpayers can structure transactions whereby they sell separate parcels and acquire replacement properties in one exchange. More than one taxpayer can combine their interests in a transaction and effectuate a 1031 Exchange. Tenancy-in-common arrangements may also allow several taxpayers to combine their interests in exchange properties and effectuate a 1031 Exchange. Both investors and non-investors may utilize a 1031 Exchange to obtain property which they will use in a business, trade, or held for investment.

Qualifying Criteria

To qualify for a 1031 Exchange, property an owner holds must be like-kind, which means it has to be of the same nature or character, regardless of their grade or quality. Although both properties do not need to be of the same value, when you trade properties, you should ideally make a profit or gain value from the transaction that you intend to reinvest. If you do not do this, you will have to pay capital gains tax. However, a 1031 Exchange can only defer investment properties rather than personal properties.
It is important to note that 1031 Exchanges typically only apply to real estate. This means it does not usually apply to personal property which includes things you own for yourself like a primary residence, vacation home, clothing, furniture, and even stocks and bonds.
Both your old and new properties must be either investment or business use properties. A vacation house does not qualify as the primary home, it should be used to generate rental income if you would like to qualify for a 1031 Exchange. The investment properties on the other hand include undeveloped land, farms and ranches, rental property and commercial properties, and certain foreign properties.
Owning interest in a partnership that has real estate assets qualifies as long as the partnership owns investment property. The same goes for shares in a corporation.

Exchange Options

The 1031 rules allow for several different types of exchanges. These include simultaneous exchanges, delayed exchanges, reverse exchanges, and construction exchanges.
A simultaneous exchange is the classic or "textbook" 1031 exchange. As the name implies, it works in a way whereby the closing of the relinquished property must take place at essentially the same time as the acquisition of the replacement property. Therefore, in this situation the relinquished sale and the replacement acquisition must close in very close time proximity to each other to ensure that the transactions are simultaneous. In an ideal situation for a simultaneous exchange, you have one buyer willing to purchase your relinquished property and one seller willing to sell you their replacement property. For example, the relinquished property sale can close on a Wednesday and the replacement property acquisition can close on the following Wednesday.
A delayed exchange is what most people think of as an ordinary 1031 exchange. The more common delayed exchange is like this: A relinquished property sale closes on Monday and then the taxpayer (you, the consumer) identifies a replacement property within 45 days of the relinquished sale closing and then the replacement property acquisition closes within 180 days of the relinquished property sale closing.
A reverse exchange is a very specific 1031 exchange. With a reverse exchange, the taxpayer first acquires the replacement property and then within a certain amount of time sells the relinquished property. The reverse exchange does not allow for the full benefits of the 1031 exchange, so unfortunately it is not a perfect strategy, but it is worth mentioning for a certain set of clients.
Reverse exchanges also require the use of an exchange accommodation titleholder. The accommodator will hold either the relinquished property in exchange for the replacement property from the buyer or hold the replacement property in exchange for the relinquished property from the seller.

Function of a Qualified Intermediary

The 1031 Exchange process is a complex transaction that requires the knowledge and guidance of an experienced qualified intermediary who will act as a facilitator of the exchange and closely track the timeliness of the exchange.
The list of pitfalls is unsparing. The buyer may back out before the deal closes; the property may suffer a loss in value; an interest rate hike may occur right before closing on the replacement property; or a quiet title issue may arise.
The qualified intermediary (QI), or exchange facilitator , plays a pivotal role in the structuring and execution of a successful 1031 Exchange. The QI’s role is to select and identify potential replacement property; to assist in all elements of the closing process including incidental requirements such as parking or short-term leasing to exempt property from being "like-kind"; to accept cash proceeds from the sale of the relinquished property and invest them in the replacement property; and ultimately to assign and convey the relinquished property to the buyer as instructed and directed without taking title.
A QI is any person that is not the taxpayer/exchanger. The taxpayer/exchanger is the person that owns the relinquished property and who desires to do a 1031 Exchange. They must also acquire the replacement property to constitute a like-kind exchange. A qualified intermediary is an independent third party who drafts the purchase agreement for the relinquished property, conducts the closing, and as part of the closing, acquires the relinquished property (via an assignment) from the taxpayer/exchanger, and sells it to the purchaser of the relinquished property. The qualified intermediary must be independent from the taxpayer/exchanger.

Common Errors

Common Pitfalls and How to Steer Clear of Them
To maximize the success of a 1031 exchange, the transaction must follow the letter of the law. Breaking even minor technical rules can result in disqualification or part disqualification of an exchange. Below are several common pitfalls in which clients (and even seasoned professionals) often trip themselves up, as well as strategies for avoiding them.
Incomplete Exchange Agreement
One or both parties may be closed on the new property before the contract is fully executed. To ensure compliance with 1031, the buyer must agree to accept the proceeds on behalf of the seller into escrow as a qualified intermediary (QI). Common problems are the parties do not include the QI in the contract or do not identify the QI’s name and address.
Deed Problems
No transaction can be completed without a detailed review of the deed. There are several common mistakes the parties make by failing to:
As a result of these oversights, the deed may be considered legally ineffective.
Failure to Meet Timelines and Filing Requirements
Several deadlines are imposed on the 1031 exchange process, including:
Failure to meet these deadlines results in disqualification of the exchange, including the full realization of any deferred capital gains tax liability. To avoid missing an important deadline, you may want to consider a calendar reminder that is sent to you no later than 30 days prior to the deadline. You should consult with a 1031 exchange professional if the deadline has passed and you are not yet in compliance.
Failure to Identify Replacement Property
Though timing is key to a successful exchange, you also must make the requisite identification of the replacement property within the specific time limits. The potential replacement real estate must be identified in writing no later than 45 days after you close on the sale of the relinquished property. Beyond shortfalls in the number of properties identified, other common mistakes are:
At this point you have only 180 days to close on the replacement property to avoid tax liability. The buyer may close on a qualifying replacement property at any time during this period; however, closing on more than three replacement properties may impact whether a 1031 exchange was intended or deemed appropriate.
Avoiding pitfalls is possible through careful preparation and guidance from experienced professionals. Note the common mistakes noted above, and consult with a lawyer who specializes in 1031 exchanges with any questions or concerns about your eligibility or compliance.

Changes & Updates

There have been a few recent legislative and regulatory updates that could impact investors or participants in a 1031 Exchange.
Initial Meeting with Intermediary – The IRS now requires you to meet with the Intermediary and discuss the transaction before completing an exchange. The meeting also helps avoid any papering issues.
Foreign Financial Assets – As described earlier , one of the changes in the 2016 Protecting Americans from Tax Hikes Act is that IRC 1031 Exchanges now qualify for relief from the Foreign Account Tax Compliance Act (FATCA). This law only applies once a taxpayer has over $50,000 in foreign financial assets. In these circumstances, a Qualified Intermediary would be exempt from any withholding requirements and would not need to obtain any documentation about foreign ownership of the investor/participant. Any time the Foreign Financial Asset exceeds $5,000,000, new forms now must be filed by the parties.