Anatomy of a Like-Kind Exchange
Posted at 6:55 AM, Apr. 18, 2008
Real estate investors frequently are not fully advised of the mechanics and benefits of §1031 exchanges by their tax or real estate advisors. Section 1031 exchanges permit the non-recognition of capital gains, when investment or business property is “exchanged” for other investment or business property. Non-recognition of capital gains means simply that the taxes that would otherwise have been due on the profits have been postponed to a later date. So, how does an investor properly structure a §1031 exchange, and what will it look like.
The non-recognition provisions of §1031 have been part of the tax law for more than eighty years. For the first seventy years, there was no formal guidance from the Internal Revenue Service, leaving exchanging to the most adventurous investors, or those with the most aggressive tax counsel. In 1991, the Service issued Regulations providing detailed guidance in the form of “safe harbors.”
The first thing to keep in mind is that it is important for the taxpayer to discuss the benefits of a tax-deferred exchange with his tax advisor. Further, it is imperative that the client make the ultimate decision to participate in an exchange before the close of title on the relinquished property. The Regulations require that the taxpayer enter into an exchange agreement with a qualified intermediary at or before closing. Prudent investors, therefore, typically engage the services of a reputable qualified intermediary days or even weeks before the scheduled closing date. The ideal time to do so is immediately upon the signing of contracts for the sale of the property. This enables the intermediary to coordinate with the attorney and other professionals associated with the transaction.
At that time, it is wise to provide the intermediary with a clear copy of the real estate contract. The intermediary will use the information contained in the contract in a myriad of ways during the exchange process. The first is to obtain the names of the taxpayer and of the buyer, as well as the address and price of the relinquished property. The intermediary will typically contact the attorney at this point to inquire about any details that may be unique to the transaction
Further, the intermediary will prepare the exchange agreement, paying particular attention to language and terms specifically required by the Regulations. Additionally, the taxpayer must assign his rights under the real estate contract to the intermediary.
As closing approaches, the intermediary will contact the closing agent to determine familiarity with the exchange process, and to ensure that the closing procedures comply with the Regulations. At the closing, the purchaser will acknowledge that the taxpayer had embarked upon an exchange and had assigned his rights to the intermediary. Closing costs, attorney fees, mortgage payoffs, and other items routinely paid from the seller’s funds are paid at the closing table. Any remaining funds that would otherwise be paid to the taxpayer are, at this time, paid to the intermediary on behalf of the taxpayer. This is crucial, because the taxpayer must avoid even “constructive receipt” of the proceeds in order to protect the validity of his exchange.
During the exchange, with very few exceptions, taxpayers may have no access to the exchange proceeds. The taxpayer may receive the exchange proceeds upon the 46th day, if he has not previously identified replacement property. (More on this later.) The taxpayer may also receive the exchange proceeds upon the 181st day, if he does not actually acquire all of the previously identified replacement property. Between the 45th and 181st days, the taxpayer may only receive his exchange proceeds upon the occurrence of a material contingency related to the acquisition of the replacement property, that was provided for in the purchase contract, and which is beyond the control of the buyer and seller. An example of such a contingency would be the denial of a zoning change request. Failure to obtain financing on terms satisfactory to the taxpayer, or the seller removing the property from the market are not regarded as such contingencies.
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