Internal Revenue Code 1031 Tax Free Exchanges

Follow the Rules!
Internal Revenue Code 1031 Tax Free Exchanges -
 
When property held for investment or business purposes is sold for more than its original purchase price, any gain from the sale is subject to capital gains tax. However, an IRC Section 1031 exchange—also called a tax-deferred exchange— allows a sale of the investment or business property and a purchase of a like-kind replacement property without paying the capital gains tax. The sale proceeds can be reinvested without paying additional taxes.  Used correctly, the 1031 Exchange is a powerful money-saving tool. But there are rules.  Lots of rules. Breaking the rules means the client’s profit on a sale will result in tax liability in the year of the sale.
 
Most importantly, we as real estate agents are not (generally) tax professionals and cannot give advice regarding the complexities of the Internal Revenue Code.  It is complicated. It changes. And it is  a violation of the code of ethics to offer advice on subjects in which we are not qualified. We should, however, have a general understanding of the process and know what language to use in Purchase Agreements to facilitate the process– both when the client sells the relinquished property and when the client buys a replacement property.  If your client does not have a sophisticated understanding of the portions of the United States Code governing 1031 tax-deferred exchanges, consider advising your client to hire a qualified tax exchange professional.  
 
Steps to be followed by an investor for a successful 1031 tax deferment:

1. Sell the Relinquished Property and include GAR Special Stipulation 508 in the Purchase and Sale Agreement
The initial step is selling the property that the client wants to use as part of the exchange.  This property is commonly referred to as the "relinquished property."
To facilitate the 1031 exchange, you will want to insert special language in the Purchase Agreement referencing the 1031 exchange and allowing the Purchase Agreement to be assignable. This clause is important because the Buyer will have to sign certain exchange documents in order for you to successfully complete your 1031 exchange.
 
GAR Special Stipulation 508
“In selling the Property, Seller may elect to utilize an I.R.C. Section 1031 tax deferred exchange where the proceeds from the sale of the Property are used by a qualified intermediary to purchase like/kind property. In such event, Buyer agrees to cooperate with and assist Seller in connection with Seller’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary. Notwithstanding the above, Seller shall pay additional expenses, if any, in connection with Seller’s exchange of Property. Moreover, Seller shall remain fully obligated to perform all obligations of Seller under the Agreement even after it has been assigned to a qualified intermediary.” 


1. Select A Qualified Intermediary and Execute an Exchange Agreement
The client must enter into an Exchange Agreement with Qualified Intermediary.  A key aspect of a 1031 exchange is that the client is not simply selling one property and then using the proceeds from that sale to buy another. Rather, the selling of the relinquished property and buying of the replacement property is conducted as one transaction. To achieve this, the client will generally use a third party that will handle the funds throughout the exchange, that is, to conduct the transaction. The Exchange Agreement allows the intermediary to receive the funds from the sale of the relinquished property, hold those funds, and then use them to purchase the replacement property. To receive the tax-deferment benefits of a 1031 exchange, the client must not have direct control over the funds from the sale of the relinquished property, otherwise the IRS will treat this as a sale and subsequent purchase—not a 1031 exchange. The Exchange Agreement should provide that the client will be assigning seller's rights for the relinquished property and buyer's rights for the replacement property to the intermediary, so it can act on the client’s behalf without you ever directly controlling the funds involved in the exchange.  The Exchange Agreement must be accomplished before the closing date for the sale of the relinquished property.

3. Purchase the replacement property and include GAR Special Stipulation 506 in the Purchase and Sale Agreement
 
Be sure that the Purchase Agreement for the replacement property includes the following GAR Special Stipulation 506 to facilitate the assignment of the purchase to the Intermediary.  The client must identify the replacement property in writing and deliver it to a party to the transaction, either the Seller of the replacement property or the Qualified Intermediary within the 45-day timeframe.  (In some cases, the Intermediary will purchase the property on the client’s behalf.)  The client must complete the exchange and receive title to the replacement property within 180 days of the sale of your relinquished property or the due date of the income-tax return for the year in which such property was sold—whichever date is earlier. Make sure that your client watches the closing date in the purchase to be sure it complies.
 
GAR Special Stipulation 506
 
“In purchasing the Property, Buyer may elect to utilize an I.R.C. Section 1031 tax deferred exchange by trading Property with a qualified intermediary. In such event, Seller agrees to cooperate with and assist Buyer in connection with Buyer’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary. Notwithstanding the above, Buyer shall pay additional expenses, if any, in connection with Buyer’s exchange of Property. Moreover Buyer shall remain fully obligated to perform all obligations of the Buyer under the Agreement even after it has been assigned to a qualified intermediary. “
 
There are both state and federal tax filing requirements with very specific timing requirements.  The client or the client’s tax and legal professionals will advise. 

The deadlines bear repeating.  If the client does not strictly adhere to these deadlines, the 1031 exchange will be invalid. Extensions are unlikely.
• The client has 45 days from the date of closing on the sale of relinquished property to identify potential replacement property/properties and the exchange must be completed within 180 days of that date
• These timeframes include business days, holidays, and weekends. 
2. Sell the Relinquished Property and include GAR Special Stipulation 508 in the Purchase and Sale Agreement

The initial step is selling the property that the client wants to use as part of the exchange.  This property is commonly referred to as the "relinquished property."
To facilitate the 1031 exchange, you will want to insert special language in the Purchase Agreement referencing the 1031 exchange and allowing the Purchase Agreement to be assignable. This clause is important because the Buyer will have to sign certain exchange documents in order for you to successfully complete your 1031 exchange.
 
GAR Special Stipulation 508
“In selling the Property, Seller may elect to utilize an I.R.C. Section 1031 tax deferred exchange where the proceeds from the sale of the Property are used by a qualified intermediary to purchase like/kind property. In such event, Buyer agrees to cooperate with and assist Seller in connection with Seller’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary. Notwithstanding the above, Seller shall pay additional expenses, if any, in connection with Seller’s exchange of Property. Moreover, Seller shall remain fully obligated to perform all obligations of Seller under the Agreement even after it has been assigned to a qualified intermediary.” 

1. Select A Qualified Intermediary and Execute an Exchange Agreement

The client must enter into an Exchange Agreement with Qualified Intermediary.  A key aspect of a 1031 exchange is that the client is not simply selling one property and then using the proceeds from that sale to buy another. Rather, the selling of the relinquished property and buying of the replacement property is conducted as one transaction. To achieve this, the client will generally use a third party that will handle the funds throughout the exchange, that is, to conduct the transaction. The Exchange Agreement allows the intermediary to receive the funds from the sale of the relinquished property, hold those funds, and then use them to purchase the replacement property. To receive the tax-deferment benefits of a 1031 exchange, the client must not have direct control over the funds from the sale of the relinquished property, otherwise the IRS will treat this as a sale and subsequent purchase—not a 1031 exchange. The Exchange Agreement should provide that the client will be assigning seller's rights for the relinquished property and buyer's rights for the replacement property to the intermediary, so it can act on the client’s behalf without you ever directly controlling the funds involved in the exchange.  The Exchange Agreement must be accomplished before the closing date for the sale of the relinquished property.

3. Purchase the replacement property and include GAR Special Stipulation 506 in the Purchase and Sale Agreement
 
Be sure that the Purchase Agreement for the replacement property includes the following GAR Special Stipulation 506 to facilitate the assignment of the purchase to the Intermediary.  The client must identify the replacement property in writing and deliver it to a party to the transaction, either the Seller of the replacement property or the Qualified Intermediary within the 45-day timeframe.  (In some cases, the Intermediary will purchase the property on the client’s behalf.)  The client must complete the exchange and receive title to the replacement property within 180 days of the sale of your relinquished property or the due date of the income-tax return for the year in which such property was sold—whichever date is earlier. Make sure that your client watches the closing date in the purchase to be sure it complies.
 
GAR Special Stipulation 506
 
“In purchasing the Property, Buyer may elect to utilize an I.R.C. Section 1031 tax deferred exchange by trading Property with a qualified intermediary. In such event, Seller agrees to cooperate with and assist Buyer in connection with Buyer’s like/kind exchange and execute an assignment of this Agreement to the qualified intermediary. Notwithstanding the above, Buyer shall pay additional expenses, if any, in connection with Buyer’s exchange of Property. Moreover Buyer shall remain fully obligated to perform all obligations of the Buyer under the Agreement even after it has been assigned to a qualified intermediary. “
 
There are both state and federal tax filing requirements with very specific timing requirements.  The client or the client’s tax and legal professionals will advise. 

The deadlines bear repeating.  If the client does not strictly adhere to these deadlines, the 1031 exchange will be invalid. Extensions are unlikely.

• The client has 45 days from the date of closing on the sale of relinquished property to identify potential replacement property/properties and the exchange must be completed within 180 days of that date
• These timeframes include business days, holidays, and weekends.