What is a §1031 Exchange?

A like-kind exchange is permitted under Section 1031 of the U.S. Internal Revenue Code and allows an investor who holds property “for productive use in trade or business or for investment” to sell that property and purchase another like-kind property or properties that qualify within the IRS rules without paying capital gains taxes on any appreciation realized in the sale of the first property.
Although the properties exchanged are called “like-kind” it does not mean that the properties “exchanged” have to be a shopping center for a shopping center or an apartment building for another apartment building. Rather it means the properties have to be like-kind in the sense that the exchange property has to also be held “for productive use in trade or business or for investment.” This could mean exchanging a hotel for an office building, a commercial property for unimproved property, or an industrial building for a multi-family property.
There are four key elements to consider in the process: the qualified intermediary, the time requirements, information needed for the exchange, and the unique handling of closing and escrow.
Qualified Intermediary or Facilitator
A QI or facilitator is an intermediary that stands in the shoes of the exchanger or seller to relinquish the property to the new buyer, and likewise transfers the replacement property to the exchanger who is now buying a new property. Under the IRS rules, this provides the exchanger a “safe harbor” from capital gains taxes, since the exchanger never has access to the proceeds from the sale.
Time Requirements
From the day that a taxpayer sells the first property, he or she has 45 days to identify a replacement property or properties. Then the taxpayer has 180 days to close on a replacement property. During that time, the QI is holding the funds realized from the first sale in escrow, in a segregated account, to be used when the replacement property is purchased.
Information Needed
The QI will need a lot of information about the property that is being sold, for instance when it was acquired, how much the taxpayer paid for it, what was the use of the property and how was it vested. They will also need to know what the taxpayer is interested in acquiring.
The Closing of Escrow
The QI stands in the shoes of a seller, in the case of a relinquished property, or in the shoes of the buyer, in the case of a replacement property. The escrow agent will send the purchase agreement, title commitment, closing estimates, etc. to the QI as the substitute buyer or seller. The exchanger – the buyer or seller – should acknowledge all preliminary and final closing statements, but ultimately, they must be signed by the QI. Since the exchanger never touches the funds, the funds will be wired to or from the QI as well. While the QI handles the funds, the deed itself is directly deeded from the buyer to the seller in both cases to avoid duplicate transfer and conveyance fees.
Cautionary Note
This is a simple overview of a very complicated process that is provide solely for informational and educational purposes. As with all complicated real estate transactions, buyers and sellers should seek out attorneys and certified public accountants who have expertise in these areas to make sure they are receiving the best guidance possible before entering into the exchange process.