What is a 1031 like-kind exchange?
The Tax-Deferred Exchange, as defined in Section 1031 of the Internal Revenue Code of 1986, as amended, offers real estate investors one of the last, great investment opportunities to build wealth and save taxes. By completing a like-kind exchange, the investor (Exchange Party) can dispose of investment property, use all of the equity to acquire replacement investment property, defer the capital gain tax that would ordinarily be paid, and leverage all of the equity into the Replacement Property.
Requirements for full 1031 tax deferral.
Two requirements must be met to defer the capital gain tax:
- the Exchange Party must acquire "like-kind" Replacement Property, and
- the Exchange Party cannot receive cash or other benefits (unless the Exchange Party pays capital gain taxes on the money).
- All real property is "like-kind" with all other real property. "Like-kind" refers to how the property is held by the investor, not the type or character of property. The Exchange Party must have held the Relinquished Property for investment, or for "productive use in their trade or business", and intend to do the same with the Replacement Property. The following are examples of "like-kind" property:
- Residential for commerical
- Bank building for swamp land
- Bare land for rental residential
- Fee simple interest for 30-year leasehold
- Single-family rental for multi-family rental
- Non-income producing for income producing
- Rental mountain cabin for a dentist office in which the Exchange Party intends to practice
- If the Exchange Party is exchanging personal property, the rules are far more restrictive. Definitions of what is considered real property and personal property can vary from state to state. It is essential to consult with a tax advisor when structuring personal property like-kind exchanges because one transaction may have multiple exchanges, involving 1031 tax deferral on both personal and real property. Personal property is considered "like-kind" only if it appears in the same General Asset Class or Product Class. Therefore, the Exchange Party must exchange:
- Corporate twin-engine aircraft for a corporate jet
- Dump truck for a dump truck
- Garbage routes for garbage routes
- Tofu equipment for tofu equipment
Any two properties that do not meet the definition of "like-kind" as described above.
Like-kind exchange how to:
Step 1: Find a Qualified Intermediary to assist you with the like-kind exchange as early in the sale process as possible. Key points to consider in selecting a Qualified Intermediary are knowledge and experience of its staff; local assistance for your real estate agent, CPA and attorney; and, of especially critical importance, the safety of your funds while held by the Qualified Intermediary. Unlimited Exchange would be happy to serve as your Qualified Intermediary - simply pick up the phone and call or fill out one of our online forms and fax or email it to us to get the process started or your questions answered.
Step 2: Instruct your real estate agent to include an "Exchange Cooperation Clause" as an addendum to the purchase and sale agreement on the Relinquished Property (the property the Exchange Party is selling to the buyer).
An example Exchange Cooperation Clause is: "Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC Section 1031 Tax-Deferred Exchange that will not delay the closing or cause additional expense to the Buyer. The Seller's rights under this agreement may be assigned to a Qualified Intermediary for completing such an exchange. Buyer agrees to cooperate with the Seller and the Qualified Intermediary in a manner necessary to complete the like-kind exchange."
Step 3: Contact your Qualified Intermediary as soon as possible after escrow is opened or after entering into the purchase and sale agreement and advise it well in advance of the closing date. The Qualified Intermediary will draft the appropriate Exchange Agreement, Assignment Agreement, and Exchange closing instructions so they can be executed prior to closing on the property being sold.
See the checklist under the "Forms" section for more detailed explanations.
- Review the transaction with legal and tax advisors.
- Contact Unlimited Exchange.
- Enter into Sales Contract to sell the Relinquished Property and provide a copy to Unlimited Exchange, together with contact information for the closing agent or title company.
- Unlimited Exchange will prepare the documents, forwarding the documents to the closer.
- Close on the sale of the Relinquished Property. The proceeds from the sale will be transmitted to Unlimited Exchange to be held for your benefit.
- The Identification Period (45 days) begins upon the transfer of the Relinquished Property.
- Complete and sign the Identification of Replacement Property and forward to Unlimited Exchange before midnight of the 45th day following the transfer of the Relinquished Property.
- The Exchange Period (180 days) begins upon the transfer of the Relinquished Property.
- Enter into Purchase Contract to purchase the Replacement Property and provide a copy to Unlimited Exchange, together with contact information for the closing agent or title company.
- Unlimited Exchange will prepare the exchange documents, forwarding the documents to the closer.
- Close on the purchase of the Replacement Property. Unlimited Exchange will wire the funds to the closer to complete the purchase.
- If all exchange funds are used to acquire the Replacement Property, and all the requirements for a proper exchange are met, the like-kind exchange is complete.
- Complete all reporting to the Internal Revenue Service. Enjoy your new property.