BASIC STEPS AND CONSIDERATIONS FOR A SECTION 1031 EXCHANGE

Introduction: A possible tax deferred exchange under §1031 of the Internal Revenue Code of 1986, as amended (“IRC”), is something every seller who has not used the property to be sold as his/her principal residence for two or more of the past five years may wish to consider as a means to avoid capital gains tax. A successful tax deferred exchange under §1031, however, requires some basic pre-planning and coordination as well as the use of a qualified intermediary in order to prevent any deemed or constructive receipt of the sales proceeds from the relinquished property which would destroy the tax deferral of such sale. This summary of the steps involved in a 1031 exchange provides a preliminary overview and does not address all issues involved in a 1031 exchange and is not meant to replace the requirement that a would be exchanger should always review the entire transaction with tax and/or legal advisors. Likewise, it does not address the issues of so-called reverse exchanges and other variations to the typical sale and purchase sequence. This said, the following is an outline of the steps in a 1031 tax deferred exchange of real property.
*
1. Basic Requirements: To qualify for a tax deferred exchange, a few basic elements must be satisfied: (a) both the relinquished and replacement properties must be like kind real property - i.e., held for rental/investment; (b) typically, the taxpayer seeking to defer tax is one or more individual taxpayers reporting their real estate transactions on their individual Form 1040 tax returns (although entities such as limited liability companies can utilize 1031 exchange procedures); (c) the relinquished and replacement property are both within the United States of America; and (d) a qualified intermediary and qualified trust accounts are utilized for the proceeds of the relinquished property to ensure that the taxpayer(s) are not in actual or constructive receipt of the sales proceeds of the relinquished property.
*

2. Sales Contract for the Relinquished Property: The first step in a tax deferred exchange is to execute an assignable sales contract that describes the seller as the exchanger “or assigns.” In addition, it is also advisable to include a “cooperation clause” in the sales contract. An example of such a clause is as follows:
*
Tax Deferred Exchange by Seller. Seller may structure the transfer of the Property as a tax deferred exchange to Seller pursuant to Section 1031 of the Internal Revenue Code, and Purchaser agrees to cooperate with Seller, and to take such action as Seller may reasonably request in order to consummate such transfer. Seller is granted the authority to transfer its rights to this Agreement but not its obligations under an Assignment of Rights Under Contract or similar document to be signed by a qualified intermediary to be selected by the Seller, such assignment to be acknowledged by Purchaser prior to passing title and ownership. At the request of Seller, Purchaser will sign the written Assignment of Rights Under Contract referred to in this paragraph with the clear understanding that all obligations under the Agreement remain with Seller and that Seller shall directly deed the legal title to the Property over to the Purchaser as noted in the agreements between Seller and the qualified intermediary. In connection with the foregoing, Purchaser will have no obligation to (a) acquire or enter into the chain of title to any property other than the Property, or (b) incur any cost, liability or obligations of any nature whatsoever as a result of its limited participation in the exchange for which Purchaser would not be reimbursed by Seller at Closing.

As noted below, in contracting to purchase the replacement property, similar provisions should be utilized.
*
3. Exchange documents: Once the sale contract is executed, the Seller must enter into exchange documents for the relinquished property sale pursuant to which among other things (a) the sale contract is assigned by the Seller to the qualified intermediary, (b) the Purchaser acknowledges the assignment of the sales contract to the qualified intermediary, (c) the qualified intermediary agrees to receive the sales proceeds and hold the same pending their application to the purchase price of the replacement property, (d) Seller agrees to deed the relinquished property directly to the Purchaser, and (e) the Seller agrees to indemnify the qualified intermediary from loss, damage or liability except for that arising from the qualified intermediary’s breach of its obligations under the exchange documents.
*
4. Relinquished Property Sale Closes: Pursuant to the assignment agreement and exchange documents, the Seller directly deeds the relinquished property to the Purchaser and the sale proceeds for the relinquished property are transferred directly to the qualified intermediary. Note: the settlement statement will be signed by the qualified intermediary, as seller, not the exchanger.
*
5. 45-Day Identification Period & 180-Day Exchange Period The timelines for the 45-day identification period and 180-day (or the date the tax return is due, whichever is earlier) period for closing on the purchase of the replacement property begins on the date the sale of the relinquished property closes. The 180-day exchange period establishes a deadline that the purchase of the replacement property MUST be closed not later than 180 days from the closing date of the sale of the relinquished property.
*
6. Identification of the Replacement Property (or Properties): The Seller/Exchanger must properly identify replacement property (or properties where replacement properties of lesser values than the relinquished property are to be acquired) by midnight of the 45th day after the closing date of the sale of the relinquished property. This means that the Seller/Exchanger must deliver written identification of the replacement property to the qualified intermediary by midnight of the 45th day after the closing date of the sale of the relinquished property is forwarded to API.
*
7. Purchase Contract for the Replacement Property. The Exchanger must execute an assignable purchase sales contract that describes the purchaser as the exchanger “or assigns.” In addition, it is also advisable to include a “cooperation clause” in the purchase contract similar to that described, above, for the sales contract.
*
8. Coordinate With Qualified Intermediary: Once the purchase contract for the replacement property (or properties) has been executed, the exchanger must notify the qualified intermediary of the terms of the purchase contract and assign the same to the qualified intermediary. The qualified intermediary will execute the exchange documents for purchase and prepare to apply the funds held from the sale of the relinquished property against the purchase price of the replacement property at settlement on the replacement property.
*
9. Conclusion of Exchange: At closing of the purchase of the replacement property, the qualified intermediary will direct the seller of the relinquished property to deed title thereto directly to the exchanger and will apply the funds derived from the sale of the relinquished property against the amount owed from the buyer on the settlement statement. Note: the settlement statement will be signed by the qualified intermediary, as buyer, not the exchanger.
*

Conclusion: When properly done, a Section 1031 tax deferred exchange can be a very powerful tool to defer tax consequences. However, to avoid potential pitfalls and to ensure that appropriate exchange documentation is utilized and that a proper qualified intermediary is used, would be exchangers should be sure to consult their with tax and/or legal advisors. Any deemed receipt of sale proceeds, a failure to identify replacement property within the statutory 45-day period, or a failure to consummate the purchase of the replacement property with in the 180-day exchange period can be fatal.