AS A TAX PROFESSIONAL, WHY CAN'T I HOLD THE MONEY DURING AN EXCHANGE?
The Treasury Regulations state that a non-disqualified party has to hold the money for a §1031 Exchange to work. IRC states that in a §1031 that the Qualified Intermediary provides a safe harbor for the exchange. That would disallow the exchange. A disqualified party is a person who has business dealings with the client within the past two years. As a Tax Professional of the client, you are considered a disqualified party and are therefore not allowed to hold the exchange proceeds.
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 by assuring adherence to these guidelines.
WHAT IS A QUALIFIED INTERMEDIARY?
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. He or she may have a financial or tax advisor, but ultimately the taxpayer will be writing the check to the Internal Revenue Service if he or she decides to sell and pay the capital gains tax. You should, however, advise your client to contact a Qualified Exchange Intermediary and find out if a §1031 exchange makes sense for them.
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.”
WHAT DOES “LIKE-KIND” MEAN?IRC §1031(a)(1) allows for the exchange of property held for productive use in a trade or business or for investment for like-kind Replacement Property. A myriad of court cases and IRS rulings have established the definition of “like-kind” real estate to be very broad. Examples of like-kind property include single-family rentals, multi-unit housing, commercial or industrial properties, ranches, and bare land. Provided a property has not been personally used, such as a principal residence or second home, it should qualify for a §1031 Exchange.
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 during the time 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?
The Intermediary should be carefully chosen to ensure the exchange is defensible. As a principal in the transaction, the Intermediary will have as much responsibility as the Exchangor for performance of contractual obligations in the selling and buying of property. The real estate agent for the Exchangor will become the real estate agent for the Intermediary and, if the agent is unfamiliar with exchanging, it may be the Intermediary's responsibility to ensure that the transaction is conducted properly.Your client should select a 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 over two decades!
HOW ARE MY CLIENT’S EXCHANGE FUNDS PROTECTED?
Starker Services, Inc. is a leading Qualified Intermediary, offering its clients two decades of 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 account, adding another layer of security and making SSI one of the safest QI’s in the nation. It is also Starker’s policy to require two Corporate Officer signatures 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, both of which 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 to 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 the day the relinquished property is 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 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 equal to or more than their capital gain, then they will be paying all the tax owed anyway. 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.