Section 1031 Exchange for Real Estate Investors – The Basics of Replacement Property
During a 1031 exchange, the IRS requires the use of a Qualified Intermediary (QI). The QI is responsible for documenting and managing the process of a 1031 exchange under Internal Revenue Code Section 1031. This article reviews the role of a QI and what to look for when choosing one.
Section 1031 allows an investor to sell real estate for a gain and then roll the proceeds into another “like-kind” asset. This type of transaction is called a “1031 exchange,” which allows the investor to defer paying capital gains tax on the property which was sold.
1031 Deferred Exchange
Tax deferral means that the taxes are not due now. Rather, the taxes are on hold until a later date, perhaps years in the future. The deferred taxes on the sale of the property will eventually become due one day when the replacement like-kind property is sold without another 1031 exchange.
Nevertheless, the deferral of capital gains means less taxes to pay now and more money to invest for the future. This is a great way to speed the growth of a real estate portfolio. However, failing to meet IRS requirements can result in a failed exchange, where the deferred taxes become immediately due.
Check out our article here which includes the mechanics of 1031 exchanges.
1031 Exchange Process
The 1031 exchange process involves several critical steps to ensure a successful tax-deferred exchange. It begins with the sale of the property, which must be held for investment or business use. The proceeds from this sale are then entrusted to a qualified intermediary, who will use these funds to acquire the replacement property.
Timing is important in a 1031 exchange. The replacement property must be identified within 45 days of selling the relinquished property. Following this, the purchase of the replacement property must be completed within 180 days. These strict timelines are mandated by the Internal Revenue Code to qualify for tax deferral.
Throughout the exchange process, the qualified intermediary plays an important role. They ensure the exchange is structured correctly and that the taxpayer’s funds are securely held. Typically, the qualified intermediary will provide a written exchange agreement, detailing the terms of the exchange and their responsibilities.
Working with an experienced qualified intermediary is important. They should have a deep understanding of the Internal Revenue Code and the regulations governing 1031 exchanges. Their expertise will guide you through the process, ensuring compliance and safeguarding your investment.
Qualified 1031 Intermediary in Real Estate
The IRS has stringent regulations for a 1031 exchange. Using a Qualified Intermediary to document your transactions and hold your proceeds is a very important and required part of the 1031 exchange.
The rules state that an unrelated third party (the Qualified Intermediary) must document and manage the 1031 exchange process. The rules also specify that a disqualified person, such as a family member or someone with a business relationship with the taxpayer, cannot act as a QI. The QI does not complete any other part of the real estate transaction.
The taxpayer will also need to use a real estate attorney, a title company, a CPA or accountant for tax reporting and a real estate agent. The QI is an additional professional added to this team specifically for 1031 exchanges. In addition to their required role, you want a QI that acts as an information resource through the entire 1031 process.
CPA Tip: I recommend hiring a Qualified Intermediary from the very start. A QI must be involved before the closing of the sale of the property that you are looking to replace with the exchange. If the property is already sold without the use of a Qualified Intermediary, a 1031 exchange cannot take place.
Who is a Qualified Intermediary for a 1031 Exchange?
The Qualified Intermediary is an unrelated third party. This means that your QI cannot be related to you or your transaction in anyway. The QI cannot be your attorney or CPA. They cannot be a family member. And they must be completely unrelated to complete your documentation and manage the 1031 exchange.
The IRS clearly disqualifies anyone if there’s an agency relationship, a business relationship, or a family relationship from being the Qualified Intermediary during the 1031 exchange. This includes individuals such as an attorney, accountant, or investment banker who have served as an agent for the taxpayer within a two-year period. There is no specific rule outside of those disqualifiers on who may be used as a QI. We caution you not to be too hasty when choosing a QI, however.
Let’s look at the major reasons to carefully consider a professional and experienced QI.
What does a 1031 Exchange Qualified Intermediary Do?
During a 1031 exchange, the Qualified Intermediary will work alongside you and the rest of your team to document the entire 1031 exchange process from beginning to end. The QI will also hold the exchange proceeds of your sale.
You should hire a QI that is able to do the following:
- Create an exchange agreement between you and the QI
- Provide the Assignment of Contract Rights that will be signed by you (the investor) and carried out by the title company
- Give notice to all parties of the transaction
- Receive and maintain sale proceeds during the transaction of the 1031 exchange in a special exchange account, until the end of the exchange
Selecting a Qualified Intermediary
Choosing the right qualified intermediary is a critical step in the 1031 exchange process. A qualified intermediary facilitates the exchange by holding the exchange funds and using them to acquire the replacement property. When selecting a qualified intermediary, several factors should be considered, including their experience, reputation, and fees.
One reliable resource for finding a qualified intermediary is the Federation of Exchange Accommodators (FEA). This trade association lists qualified intermediaries who have met specific standards and are members of the organization.
When evaluating potential qualified intermediaries, it’s essential to ask the right questions:
- How long has the qualified intermediary been in business?
- How many exchanges have they completed in the last five years?
- What is their fee structure?
- How will they hold the exchange funds?
- What types of insurance do they carry?
These questions will help you assess their experience and ensure they can securely manage your exchange funds. Selecting a qualified intermediary with a solid track record and a transparent fee structure will provide peace of mind and contribute to a successful 1031 exchange.
Exchange Agreements and 1031 Exchanges
An Exchange Agreement is a document drawn up between you and your Qualified Intermediary that lays out the requirements of a 1031 exchange. This agreement will specify the steps you will take to complete your 1031 exchange and what tasks your QI will fulfill.
This Exchange Agreement is the contract between you and your QI. It enables you to utilize the qualified intermediary safe harbor.
Assignment of Rights
During the process of a 1031 exchange, there must be an Assignment of Rights. Within the Assignment of Rights, you assign the rights to sell your property to your Qualified Intermediary. This document, which is prepared by your QI, will allow the title company to directly deed the properties from the exchanger to the buyer and from the seller to the exchanger.
Note that your QI should never take title to either your property or the replacement property. The QI is the assignee only on the Settlement Statement. This is part of the Assignment of Rights that you should discuss with your QI beforehand.
Notification and 1031 Exchanges
In the tax Code, there is no requirement on when the parties of an exchange must be notified, as long as they are notified at some point during the exchange. Because there are aggressive bargainers that may realize a 1031 exchange is in the works, most QIs prefer to provide the required Notification during the closing process.
Receipt and Maintenance of Exchange Proceeds for a 1031 Exchange
A mandatory rule of a 1031 exchange is that the investor may not receive the proceeds from the sale of the relinquished property. Even constructive receipt, when proceeds are not in the investor’s possession but are under their control, is prohibited. For this necessary step, you need to hire a QI before you close on the sale of your investment property.
After the closing of the sale, your proceeds must go into an exchange account, separated from you and controlled by your QI for the IRS to acknowledge the 1031 exchange. The IRS considers funds in escrow with the title company constructive receipt by the seller.
To purchase your replacement property, the funds will be transferred by the QI directly to the title company to close the deal.
Qualified Intermediary Fees
There are a few requirements in choosing the right Qualified Intermediary for a 1031 exchange. Individuals who have provided non exchange related services, such as legal or financial assistance, are also disqualified from acting as a QI. There are no licensing requirements. The main consideration is that your QI be completely unrelated and be a third party to your deal.
The QI will be holding a significant amount of money on your behalf, so I also recommend you choose a QI with extensive, verifiable experience with a credible reputation. The QI should use dual signatory segregated and qualified escrow accounts for your exchange funds.
Your QI should guarantee their exchange documentation and have someone who is easily accessible to answer your exchange questions. They will agree to provide support and documentation in case of an IRS audit. We recommend you do your research before deciding which QI is right for your exchange.
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