Section 1031 Exchanges:
What Are They & How Do They Work?
What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code allows you to defer payment of capital gains tax on the sale of property. With few exceptions, it applies to all property used in a business or held for investment. However, special rules must be followed, or any profit will be taxed at current federal and state capital gains rates.
What is the exchange agreement?
The exchange agreement is a contract between you and us designed to fit within "safe harbor" rules of the tax code. Those rules allow you to accomplish an exchange over a period of time. Without an exchange agreement, you would have to simultaneously swap the old property for the new property, something most of us aren't able to arrange. The exchange agreement allows you to transfer your old property first and then gives you a limited amount of time (45 days) to find one or more replacement properties. The replacement property will, in all likelihood, be acquired from someone other than the purchaser of the relinquished property. As long as the replacement property is properly identified within the first 45 days and acquired during the 180 days following closing of the first leg of the transaction, the IRS will recognize the exchange as valid.
The exchange agreement will require that the proceeds from the sale of your old property go to PEC. This is crucial in order to meet the requirement that you cannot be in actual or constructive receipt of any of the exchange funds. PEC will hold the proceeds from the time of sale until they are needed to close on the purchase of your new property. Proceeds held by PEC are held in separate accounts for each exchange with a federally insured bank.
Why do you need a qualified intermediary?
To be sure that your exchange is valid, you need to have a "qualified intermediary" (QI). The QI cannot be your real estate agent, attorney, or accountant—it must be an independent entity. PEC is such an entity.
What kind of property can you exchange?
Real Estate. Practically speaking, as long as there's dirt under it (and sometimes even when there's not) you can exchange it. For example, you can exchange an apartment building for a shopping center, a rental home for a piece of vacant land, or a long term lease for an office building.
Personal property. The rules on personal property are tighter. For example, trading female cattle for male cattle does not qualify as a like kind exchange. In addition, certain kinds of personal property are excluded altogether from section 1031's ambit: most importantly, partnership interests, stocks, bonds, and notes.
Who should do an exchange?
Anyone who has real or personal property used in a trade or business or held for investment and who expects to profit by selling that property ought to consider an exchange. It doesn't matter if your property is a single-family rental home or a chemical factory. The cost of the exchange is a small fraction of the amount that you will save in capital gains tax.
When should exchange planning begin?
An exchange agreement is usually signed after you have already entered into a sales contract for your relinquished property. For strategic reasons, there may be times when you will want to amend your sales agreement later, but ordinarily it is preferable to get language requiring the other party to participate in an exchange into the original agreement. The sales agreement should contain language similar to the following:
Language for exchange in lieu of sale: Seller may enter into an agreement assigning its rights (but not its obligations) under this agreement to a third party in connection with a 1031 exchange. Purchaser will cooperate in the exchange at no cost to purchaser.
Language for exchange in lieu of purchase: Purchaser may enter into an agreement assigning its rights (but not its obligations) under this agreement to a third party in connection with a 1031 exchange. Seller will cooperate in the exchange at no cost to seller.
1031 regulations allow only a short time frame within which to find new property. Starting early on your exchange planning by investigating potential replacement properties before closing on your relinquished property can help alleviate the pressure of that deadline.
If you have already closed on the sale of your property, it's too late!
Do you have to reinvest all your money?
The tax is completely deferred as long as 1) the total purchase price of the replacement property equals the sale price of the exchanged property, after deduction of the costs of sale and 2) your equity in the replacement property equals your equity in the property relinquished. If the purchase price of the new property is less than the sale price of the old property, the difference is "boot" and it will be taxed at capital gains rates. If your equity in the new property is less than your equity in the old property, the difference will also be considered taxable boot. Receipt of boot does not, however, invalidate the exchange.
A helpful way of conceptualizing boot is to remember this rule: If you are going to get cash out of the deal in any way or to any extent, you are going to pay tax on the money you take out.
Are your funds protected?
The security of your exchange funds is of utmost importance. We have relationships with several national banks specializing in the 1031 industry, as well as with local, Ann Arbor, Michigan banks. For a setup fee, we can establish your exchange account at the bank you are most comfortable working with.
We hold your exchange funds in segregated accounts in your name: They are never commingled with others’. All accounts are 100% liquid. For the greatest level of security, your funds can be held in a qualified escrow account. Funds may only be released from that kind of account by your signature together with ours. Finally, we are happy to discuss any other kind of security arrangement you may consider.
The Federation of Exchange Accommodators (FEA) is the 1031 industry's trade group. Some helpful information from its website can be found here.