RE-VISITING 1031 EXCHANGES

December 17th, 2016 by JBWK

Submitted by Conway H. Sheild, III

Twenty years ago 1031 Exchanges were very popular. Many real estate transactions involving investment properties involved an Exchange, tax deferral technique (not tax free) whereby the capital gains tax is deferred until the sale of the replacement property occurs.

 

              Once you sell an asset, generally real estate investment property (relinquished property),  Section 1031 Exchange Rules requires you  to close on a replacement property within 180 days., In addition, one  must identify the replacement property within 45 days of closing on the relinquished property.  While it is always better to do a simultaneous exchange, as that creates very little controversy with IRS, in a non-simultaneous exchange or “delayed exchange” the exchanger transfers the relinquished property and acquires the replacement property at a later date.  This could benefit a seller who may need additional time to find an attractive qualifying real estate asset to acquire, which may not be known at the date of the closing on the relinquished property.

 

            The 45-day identification requirement provides that such property must be identified as property to be received in the Exchange on or before the date that the tax payer transfers the property relinquished in the Exchange.  This can cause problems if the identification is not specific enough to identify the asset to be acquired without confusion.   The Regulations permit tax payers to identify three or more replacement properties and choose at a later date which property or properties to acquire as the actual replacement property.  This allows an exchanger the opportunity to test the market for 45 days allowing additional time to conduct due diligence or resolve any issues involving the potential replacement property.

 

            The Regulations also create a “safe harbor” permitting qualified intermediaries or accommodators to hold the exchange proceeds for the exchanger. Intermediaries must be completely neutral in this transaction with no ties to either party and the qualified intermediary should serve as the recipient of the identification notices of property to be acquired. 

 

            While the Regulations permit tax payers to identify multiple replacement properties and to decide later which of the identified properties to acquire in the Exchange, there are risks to exchangers who identify multiple replacement properties because a minor error in identifying the replacement property could render the entire exchange fully taxable.  The solution is to acquire all replacement property within the 45-day period, so the tax payer does not run into the burden of whether or not there is an identification error or problem. 

 

            There are several options in the delayed exchange identification process, although generally the rule is to identify three potential replacement properties.  There are other methods of identification which IRS recognizes under the Regulations, but a person contemplating a 1031 Exchange should always consult his or her attorney prior to identifying properties for a delayed exchange.

 

            There are plenty of good reasons why a seller of property that qualifies for a 1031 Exchange would want to defer the taxation on that property but the seller must follow the Regulations for a 1031 Exchange to be effective. However, there are a few pitfalls, and one should consult someone skilled in this process to avoid an error that could create full taxability for the sale.

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