By transferring the proceeds from the sale of a property to the purchase of a new property, a 1031 Exchange allows an investor to deffer the taxes on the proceeds of the sale of the property.
Some important rules apply:
1. All cash or other proceeds received from the sale of the relinquished property must be used to acquire the replacement property. The purchase price of the replacement property must be equal or greater than the net sale price of the property being relinquished.
2. The properties must be the same kind of property and the tax payer must identify the replacement property within 45 days of the sale of the relinquished property.
3. The property must be acquired within 180 days of relinquishing the first property, or before the taxes are due, whichever date comes first.
because of the complexity of 1031 exchange transactions investors must use a qualified 3rd party intermediary to assist.
Qualified Intermediaries
"Under Treasury Regulations section 1.1031(k)-1(g)(4), a QI is any person who is not the exchangor or a disqualified person. The same regulations define a disqualified person as any person who has acted as the exchangor’s agent within a two-year period ending on the date of the transfer of the relinquished property. This agent can include, but is not limited to, the exchangor’s employee, attorney, accountant, investment banker or broker, or real estate broker or agent. The performance of services regarding exchanges of property that are intended to qualify for nonrecognition of gain or loss under section 1031, as well as routine financial, title insurance, escrow, or trust services provided to the taxpayer by a financial institution, title insurance company, or escrow company, is not taken into account in the determination of a disqualified person. In addition, a disqualified person includes a related party as described under IRC sections 267(b) or 707(b). Clearly, the intent is to establish an independent relationship between the exchangor and the QI.
The role of the QI is to step into the exchangor’s position and to prevent the exchangor’s access to funds transferred during the exchange process so as not to violate the like-kind clause. For example, consider a Taxpayer X who wants to exchange a three-bedroom residential rental property. A newly married couple may be willing to purchase the house for their own principal residence, but has no property to exchange. Therefore, X transfers the rights to sell the three-bedroom house under a written agreement. The property is then listed with a real estate broker; when the house is sold, the QI transfers the sale proceeds to an escrow account to which X has no access. Under Treasury Regulations section 1.1031(k)-1(c), X has 45 days to identify a replacement property, beginning on the date that the relinquished property was transferred to the buyer. If a replacement property is not received within the 45-day period, X must notify the QI in writing.
Once the replacement property is identified and the QI is notified, the QI purchases the replacement property using the funds held in escrow. Under section 1031(a)(3), X has until the earlier of 1) the 180th day after the relinquished property is transferred or 2) the due date of X’s tax return (including extensions) to complete the exchange.
In a deferred exchange, there must be a written exchange agreement under which the QI facilitates the sale of the relinquished property and the acquisition of the replacement property. The QI receives the funds from the sale of the relinquished property, and the exchange agreement expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of the money or property held by the QI before the end of the exchange period [Treasury Regulations section 1.1031(k)-1(g)(4)]."