Our organization is often asked about 1031 exchanges because we represent business owners and companies that want to sell their buildings, but don’t necessarily want to pay the capital gains tax on those property dispositions. We know – huge shock! Instead, our clients want to reinvest those gains into other real estate for the benefit of their business to have newer and better facilities or potentially strictly for investment purposes. Fortunately, a properly executed 1031 exchange does allow for the capital gain to be deferred, provided that the new real estate acquired meets the criteria of a like-kind exchange and is going to be held for investment purposes.
We generally have two types of clients. The first is a company that owns the building. The second is a company, a partnership, or a limited liability company that owns a building that it then leases back from the ownership-entity. In either case, a 1031 exchange can be completed, but the motives for the sale and reinvestment of the money may be different.
Two Important Rules:
Before we look at the basic steps, there are two very important factors in any 1031 exchange transaction, and these are steadfast IRS rules that cannot be modified.
- An exchange requires a Qualified Intermediary (“QI”) to complete the exchange transaction.
- A buyer has 45 days to identify the replacement property and 180 days to close.
When these rules are broken, then there is a good chance that your 1031 Exchange will “blow up” and that tax will be due and payable.
The Basic Steps:
In the chart above, we illustrate the buyer, the seller, and the Qualified Intermediary. In addition, we cite the timeline requirements. For this article, we will assume that you are selling a property and then exchanging into a new property.
Step One: One very important factor is that your intentions to complete a 1031 Exchange need to be completed BEFORE you sell your current property. If you sell your current property before setting up the exchange with the Qualified Intermediary, you are out of luck. Even if the sale proceeds remain in escrow, you still aren’t eligible to complete an exchange. So, step one is to set up your 1031 Exchange with a Qualified Intermediary. Also worth noting is that your QI cannot be your real estate agent selling your building or finding the replacement property.
Step Two: This step of the process will begin when you officially sell your property. The funds received at closing are given to the Qualified Intermediary. That starts the clock ticking on your 45-day window to identify your replacement property (or properties). The clock also starts for the 180-day window to complete the purchase of the property and the exchange. There are some complexities to finding properties that will be acceptable exchange candidates, so it is advisable to start looking for your exchange property options before your clock starts ticking.
Step Three: On or before the expiration of the 45-day identification period, the replacement property is identified and then you will proceed to place the replacement properties under purchase agreement. The offer letter and purchase contract require a provision stipulating that you, as the buyer, intend to complete a 1031 exchange and that the seller will reasonably agree to execute the required documents to complete the exchange.
Step Four: The job of the Qualified Intermediary is to facilitate the transaction, including holding the funds from the prior property sale and distributing funds to the seller of the property that you are purchasing as the replacement property. In addition, the Qualified Intermediary documents the exchange so that all IRS rules are followed pertaining to the exchange, and providing a full accounting of the transaction. In effect, the QI buys the replacement property on your behalf and then transfers the replacement property deed to you.
However, you as the buyer are still responsible for the due diligence and evaluation of the property. If the property passes all of your requirements, you instruct the Qualified Intermediary to proceed to closing - and the QI completes the exchange transaction.
Provided the steps are followed and the documentation is completed as required by the IRS, then the 1031 Exchange should allow you to defer the tax that would otherwise be due at the corresponding capital gains rate. The IRS does have a “look back” period to evaluate these exchanges. If the IRS determines that the rules were not followed to the “T”, then the IRS can require the tax to be paid pertaining to the prior building sale. This is why you want to have a very competent QI completing your transaction, and make certain the QI has errors and omissions insurance.
While the 1031 Tax Deferred Exchange has many steps, it is a tremendous opportunity for businesses and business owners to harness and redistribute their real estate equity and capital from existing real estate into new and better real estate without paying capital gains tax.
ITRA Global is an organization of real estate professionals specializing in representing commercial tenants and buyers in the leasing, acquisition and disposition of office, industrial and retail facilities. With coverage in major markets around the world, ITRA Global is one of the largest organizations dedicated to representing tenants and occupiers of commercial real estate. Clients benefit by having an experienced professional as their trusted advisor, providing conflict-free representation with total objectivity. To learn more about conflict-free representation and ITRA Global locations, please visit www.itraglobal.com or contact Beth Wade, ITRA Global Executive Director, at 706.654.3201 or email bwade@itraglobal.com.
Article submitted by Wayne Teig / ITRA Global Minneapolis-St. Paul, Minnesota USA
