As an Attorney or Escrow Officer, why can’t I hold the money during an exchange?The IRS states that a Qualified third party must hold the exchange proceeds for a §1031 Exchange to work. IRC states that in a §1031, the Qualified Intermediary provides a safe harbor for the exchange. As an attorney or escrow officer, you are considered a disqualified party and are therefore not allowed to hold the exchange proceeds. To do so would disallow the exchange. A disqualified party is considered any person who has business dealings with the client within the past two years.
HOW DOES A §1031 EXCHANGE AFFECT MY SETTLEMENT STATEMENT?
It is important for you to read the instructions sent to you by the Qualified Intermediary. Please click here for a list of sample HUDS.
WHAT IS A TAX DEFERRED EXCHANGE?
Internal Revenue Code Section 1031 allows taxpayers the opportunity to defer capital gains taxes owed upon the sale of investment or income property by exchanging the property for other like-kind property. The IRS states specific guidelines that must be followed when a Qualified Intermediary provides for a safe harbor exchange.
WHAT IS A QUALIFIED INTERMEDARY?
A "Qualified Intermediary" is a person other than the Exchangor or a person related to the Exchangor who, for a fee, acts to facilitate the exchange by (i) acquiring the relinquished property from the Exchangor and (ii) acquiring the replacement property and subsequently transferring it to the Exchangor. The Intermediary serves as the conduit to acquire, sell, buy and dispose of property in order to effect a tax-deferred exchange for the Exchangor. The Intermediary isolates the Exchangor from buying and selling activity. Sometimes called "facilitator", "strawman", or "accommodator", they are not an agent of the Exchangor and have no fiduciary responsibility to the Exchangor. The Intermediary has an independent business relationship and derives an economic benefit from acting as a party to the exchange
SHOULD MY CLIENT CONSIDER AN EXCHANGE?
This is an individual decision based on the investor’s overall investment goals. They may have a financial or tax advisor, but ultimately the taxpayer will be writing the check to the Internal Revenue Service if they decide to sell and pay the capital gains tax. You should, however, advise your client to contact a Qualified Exchange Intermediary and find out if they should do a §1031 Exchange.
WHAT IS THE DIFFERENCE BETWEEN A SALE AND AN EXCHANGE?
A sale is an exchange of property for cash or other property which is not “like-kind” to real estate and therefore taxable. The IRS states that an exchange is a non-taxable sale because the taxpayer will sell investment property and replace it with investment property which is “like-kind.”
WILL MY CLIENT BE AUDITED BY DOING AN EXCHANGE?
No more than if they just sold the property. The tax deferred exchange has been a part of the Tax Code in one form or another since 1921. Just like Individual Retirement Accounts (IRA’s), if your client follows the rules and guidelines, the law allows for tax deferral until the property is ultimately sold and your client receives cash.
WHEN AND HOW SHOULD MY CLIENT BEGIN THE EXCHANGE PROCESS?
Your client must first select a Qualified Intermediary (“QI”) to facilitate the exchange. A QI is a professional company that specializes in processing §1031 exchanges. The QI’s services must be retained prior to the closing of the existing property. Waiting until after the closing will be too late!The QI is hired to prepare the exchange documentation and to hold the sale proceeds between the sale of the existing property and the acquisition of the new property. The law requires the proceeds from the sale of the existing property be kept from the control of your client until a suitable replacement property is identified and ultimately transferred to the client by the QI.
HOW SHOULD MY CLIENT SELECT A QI?
Your client should select their QI based on its expertise, experience, integrity, and years in the exchange business. Starker Services, Inc. (“SSI”) is the nation’s largest and oldest independently-owned Qualified Intermediary. SSI facilitates thousands of exchanges each year and has been doing so for almost two decades!
HOW ARE MY CLIENT’S EXCHANGE FUNDS PROTECTED?
With longevity comes stability and SSI offers its clients two decades of exchange accommodation experience. In addition, SSI maintains a fidelity bond to protect its clients from loss. Each exchange account is segregated and held in a 100% liquid savings accoung, which adds another layer of security and making SSI one of the safest QI’s in the nation. It is also Starker’s policy to require that two Corporate Officer signatures are required in order to transfer funds.
AFTER THEY’VE CHOSEN A QI, THEN WHAT?
Upon closing the sale of the relinquished property, your client must adhere to two timetables which both begin on the date the existing property is transferred. First, they must identify in writing possible replacement properties within 45 days of the closing. The QI will provide them with a form on which they may list up to three potential replacement properties of any value. Once they have completed the ID form, they must fax or mail it to the QI by midnight on the 45th day.
Second, your client must acquire at least one of the identified properties prior to the expiration of the 180 day replacement period. Again, this period begins on day the relinquished property was transferred. Your client may buy more than one of the identified properties provided they all close within the 180 day period.The inability to acquire any of the identified properties will cause an exchange to fail. There is no mechanism for alternative property selection once the 45 day identification period has elapsed.
CAN MY CLIENT TAKE SOME CASH OUT WHILE STILL DOING AN EXCHANGE?
Yes! However, any cash received will be subject to capital gains tax. Your client may take cash out at the closing of the sale property or upon completion of the exchange. Since they will be taxed on any proceeds being removed from the exchange, it will also be necessary to determine what their capital gain would be had they simply sold their property. If they take cash out in an amount equal to or more than their capital gain, then they will be paying all the tax owed. An exchange at this point would be a useless exercise.
Clients considering the sale of investment or income property should first consult their financial or tax advisor to determine if a tax-deferred exchange will benefit their long-term investment goals and retirement plans. Ultimately, your client must decide whether to take advantage of an IRC Section 1031 exchange or write a check to the IRS.This material is provided for informational purposes only and is not to be construed as tax advice. The reader is strongly advised to speak with a tax consultant before attempting to employ any of the concepts stated herein.