For the last few weeks we have discussed the IRS Code Section 1031: Like Kind Exchange.  Let’s now discuss the process or how the 1031 Exchange is actually accomplished.

1. Determine whether the property should be subject of a 1031 Exchange.

Not every property is a good candidate for a 1031 Exchange. For example, if there is significant passive activity losses whereby those losses will be greater than or equal to the gain on the sale of the property, it may not be a good fit for a 1031 Exchange.  In addition, the taxpayer[1] should run the numbers on the tax savings and consider that rates are very low now compared to what they may be down the road.  The seller should discuss the tax consequences with an accountant or tax attorney to determine whether a 1031 Exchange is appropriate.

2. Contact a Qualified Intermediary.

Assuming that a 1031 Exchange is appropriate, the taxpayer should contact a Qualified Intermediary.

A Qualified Intermediary is a person (or entity) who is not the taxpayer (or a disqualified person).  The Qualified Intermediary enters into a written agreement with the taxpayer (the exchange agreement) under which the Qualified Intermediary:

• Acquires the relinquished property from the taxpayer;
• Transfers the relinquished property to the buyer;
• Acquires the replacement property from the seller;
• Transfers the replacement property to the taxpayer.

The exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by the qualified intermediary. (See Treasury Regulations §1031.1031(k)-1(g)(4)(i).)

3. The property to be relinquished should be listed for sale.

The property would be listed whether or not there is going to be a 1031 Exchange, and there is no different procedure for a 1031 Exchange (other than including a 1031 disclosure in the sales contract), so there will be no elaboration regarding listing real property for sale at this time (maybe a future edition of This Week in Real Estate).

4. Look for replacement property(ies).

At this point, the taxpayer should start looking for replacement properties.  As discussed last week, the possible replacement property(ies) must be identified within 45 calendar days of the sale date of the relinquished property.  One easy way for a 1031 Exchange to fail is not identifying potential replacement properties in time.

5. The sale of the relinquished property.

The sale is very similar to a typical real estate sale, except the Qualified Intermediary will hold the sales proceeds in a special account.  The taxpayer cannot have access to the proceeds from the sale of the relinquished property.  From this account, the proceeds will be distributed to purchase replacement property or properties.

6. Identify the replacement property.

The replacement property or properties must be identified within 45 days of selling the relinquished property.  The property(ies) must be identified to the Qualified Intermediary.

7. Purchase the replacement property(ies).

Working with and through the Qualified Intermediary, the replacement property or properties must be purchased within 180 days of selling the relinquished property (or the next due date to file an income tax return, including extensions).  The funds for this purchase must come from the qualified intermediary’s account as discussed in step 5.  The taxpayer may bring additional cash if needed to close the transaction.