A delayed exchange is the most common 1031 exchange format, allowing real property investors the flexibility to purchase replacement property within 180 days from relinquishing their sale property. In order for the investor to defer paying capital gains tax, the IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
The term “like-kind” refers to the nature and character of the real property, rather than its quality or grade. In other words, both the relinquished and replacement properties have to be held for investment, trade or business purposes. Qualifying types of real property for 1031 exchange treatment are: Residential real estate (i.e. condos, single family residences, multi-unit), Commercial real estate, land, 30+yr leasehold interests.
What type of property is excluded from 1031 exchanges? Personal property is not eligible for 1031 exchange tax deferral. A taxpayer’s primary residence and property held primarily for resale (acquiring a property only to turn around and sell it for quick profit) are excluded from tax deferral under IRC Section 1031.
THE PROCESS
It is important that the real property investor, i.e. Exchangor, selects SCES as its 1031 accommodator prior to the sale of the relinquished property. Exchangor and SCES enter into an Exchange Agreement that not only must be signed prior to closing, but more importantly, outlines the responsibilities and duties of both SCES and Exchangor during their 1031 exchange transaction. Exchangor will also sign and acknowledge the Relinquished Property Assignment, in which SCES assumes Exchangor’s Purchase and Sale Agreement. This allows SCES to instruct the escrow officer or closing attorney to directly deed the property from Exchangor to Buyer. All net proceeds from the sale are transferred to SCES, thereby protecting the Exchangor from actual or constructive receipt of funds. The funds held on behalf of Exchangor are in an FDIC insured, segregated bank account, securely held until Exchangor is ready to close on the replacement property or has failed to property identify replacement property. (See Identification Guidelines).
IMPORTANT TIMELINES TO COMPLETE THE 1031 EXCHANGE PROCESS
IDENTIFICATION PERIOD: From the day the relinquished property closes and funds are transferred to SCES, the Exchangor has 45 calendar days to identify replacement property options. This list should be specific and in writing. The purpose of this letter is to show the IRS how the Exchangor intends to use the 1031 exchange funds held with SCES. SCES will provide Exchangor with specific identification requirements and the rules to abide by when generating the letter.
Failure to properly identify replacement property within the 45 day identification period results in SCES closing out Exchangor’s 1031 exchange file on the 46th day, which in turn causes a taxable event to Exchangor.
EXCHANGE PERIOD: As long as Exchangor has properly identified replacement property within the 45 day period, Exchangor has an additional 135 days to complete the 1031 exchange and purchase replacement property from the list given to SCES. The total timeframe to complete the 1031 exchange is 180 days. Both the 45th and 180th day are strict with no extensions provided, besides Exchangor qualifying under a disaster relief. Therefore, if you’re 180th day falls on a weekend or holiday, it is imperative the purchase transaction close the Friday before or the day before the holiday.
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment”
PURCHASING REPLACEMENT PROPERTY
Prior to the closing of the replacement property purchase, Exchangor must inform SCES as to who is acting as the escrow officer or closing attorney. 1031 exchange documents, i.e. the Replacement Property Assignment, must be signed before funds can be wired out. With this document, Exchangor is assigning the Purchase and Sale Agreement to SCES, allowing exchange funds to be released to the closing and transferring ownership from Seller to Exchanger through direct deed.
IMPORTANT REMINDERS:
· Exchangor may relinquish more than one property in a 1031 exchange. The properties that are to be relinquished should close within close proximity to one another or at least within the 45 day identification period. Failure to close within the identification period means a new exchange file must be opened with SCES. The funds from both exchange files may purchase the same replacement property. In other words, each file would be buying a percentage of the replacement property, although property ownership would be 100%.
· Exchangor may purchase multiple replacement properties. Refer to 1031 Exchange Guidelines.
· Exchangor may buy a percentage of ownership. This scenario typically arises when Exchangor invests with a partner.
· In order to defer 100% of the capital gains tax, Exchangor must purchase replacement property that is equal to or greater than the value of the property being relinquished.
· Any debt requirements being paid off from the relinquished property must be replaced in the replacement property. For example, if Exchangor is selling a property valued at $1,000,000 and has a loan payoff of $300,000, Exchangor needs to purchase another property valued at $1,000,000 and take on a new loan of $300,000. It is important to note that Exchangor may bring in cash to offset the debt requirement. But, the Exchangor may not take on a larger loan to pocket some of the exchange funds. That is considered “boot” and is taxable to Exchangor.
CONCURRENT OR SIMULTANEOUS EXCHANGE
A Concurrent or Simultaneous Exchange refers to the sale of the Relinquished Property closing the same day or one day apart from the close of the Replacement Property. Although all the documentation and preparation for a concurrent exchange is the same as a Delayed Exchange, the difference is the transfer of funds.
As we mentioned above, in a Delayed Exchange it is imperative that all proceeds from the sale of the Relinquished Property are held with the Exchange Accommodator (also known as a Qualified Intermediary), in a financially secure, segregated bank account until the purchase of the Replacement Property is ready to close. However, in a concurrent exchange, the Exchange Accommodator instructs the closing officer on the sale property to directly wire the proceeds from the sale closing to the purchase transaction.