It’s usually at the tip of everyone’s tongues when someone has a big win or sells off an asset, “Capital Gains”. Usually in the form of “Oh dang, I guess I get to pay capital gain taxes now, haha!” Or perhaps, “Oh crap, I have to pay capital gains taxes now!” As prudent as potentially worrying about paying taxes is, both these statements could potentially be tossed aside like that plate of broccolini that you really aren’t feeling for dinner. How? Through a 1031 exchange.
What Is A 1031 Exchange?
Well a 1031 Exchange, or (Internal Revenue Code Section 1031 Exchange, if you’re trying to be fancy) is an exchange for “like kind” real property (“like kind” can be defined as “of the same nature or character, even if they differ in grade or quality”). Before 2018, this type of exchange use to include a myriad of property and assets that allowed for all kinds of tax deferrals. Some examples of what used to be eligible for a 1031 exchange included, stocks, bonds and other properties. However after the passage of the “Tax Cuts and Jobs Act of 2017”, 1031 was limited to only include real property.
Time Limit?
In order to qualify for this exchange property must be “identified” to be exchanged and that exchange must happen within 180 days. Also the 1031 Exchange is considered to have started at the date of either, the date the deed records, or the date possession is transferred to the buyer, whichever is earlier. Also the exchange is considered to have ended 180 days after it begins, or the date the Exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
How To Actually Do A 1031 Exchange
Like with most things that save you money a 1031 exchange can seem complicated, but the process should generally follow the steps outlined below:
Step 1. Retain the services of an enrolled agent, or Certified Public Accountant (perhaps CPA Solutions, LLC).
Step 2. Sell the property, including the “Cooperation Clause” in the sales agreement. An example of a cooperation clause would be, “Buyer is aware that the seller’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish the same, at no additional cost or liability to the buyer.” Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.
Step 3. Enter into a 1031 exchange agreement with the Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of the relinquished property and the subsequent purchase of the replacement property. The 1031 Exchange Agreement must meet with federal tax law requirements, especially pertaining to the proceeds. Along with the basic agreement document, an amendment to escrow document is signed which names the Qualified Intermediary as seller.
Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to the Qualified Intermediary. The funds should be placed in a separate, completely segregated, money market account to insure liquidity and safety. The closing date of the relinquished property escrow is “Day Zero” of the exchange. Written identification of the address of the replacement property must be sent within 45 days, and the identified replacement property must be acquired by the taxpayer within 180 days.
Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. The document must be signed by everyone who signed the exchange agreement. It may be faxed, hand delivered, or mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney, preferably by certified mail, return receipt requested.
Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. “Seller is aware that the buyer’s intention is to complete a 1031 exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller.” An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange agreement, the Qualified Intermediary forwards the exchange funds and gross proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.
What About Boot?
In a 1031 Exchange “Boot” is any cash or any other property/consideration that is received in the like kind exchange. Unfortunately, this “Boot” is taxable and is not exempt from capital gains taxes. Some examples of “Boot” would be cash exchanged for property, debt reduction in a “like kind” exchange, excess borrowing in order to acquire property, and non-like kind property, just to name a few. If tax reduction is the goal, it is important to minimize boot in your 1031 “Like kind property” Exchanges.
1031 Exchanges are a great tool in order to possibly minimize capital gain taxes that may come from a large property sale. However rules for these kind of transactions have change significantly since the passage of the “Tax Cuts and Jobs Act of 2017”. It is important that people consult with a qualified CPA, or EA to make sure that this property exchange falls under Section 1031. Also it is important to minimize any extra property, or cash that could be considered “Boot” if tax deferral is the goal.