The 1031 exchange refers to a provision in the Internal Revenue Service code that provides for the deferment of capital gains tax associated with the sale of property. The code allows the property owner – whether they be a business or an individual – to exchange the property with another similar property as a way of circumventing the capital gains tax. There is, of course, a little more to it than that. What property owners might consider “similar,” or as the IRS calls it, “like-kind” might not accord to the IRS’ definition. And those definitions are different depending on whether you are exchanging property as a business or as an individual.
Also, there are several different types of exchanges, including those that can be done simultaneously, in which case the properties are exchanged at the same time. This is a relatively straightforward exercise, as these exchanges go. Conversely, exchanges can also be set up so that the purchase of the new property precedes the purchase of the existing property. This is not uncommon, but it is also not uncomplicated.
There are also rules around the timing of these transactions. For example, there are 45-day and 180-day deadlines that must be hit. The 45-day mark refers to the fact that the replacement property must be identified within 45 days after the close of the relinquished property. Then, the replacement property must be purchased within 180 days of the close of the relinquished property.
Managing these transactions requires knowledge and expertise. And if you want to be able to get the tax benefit out of the transaction, you must use what’s called a Qualified Intermediary. The tax code requires it.
How to select the right coordinator
There are numerous different 1031 exchange accommodators, and many of them are parts of larger title insurance companies. Some are smaller operations. In either event, you want to look for those that provide good access to their experts and are staffed with lawyers. Also, some of these companies differentiate themselves by the other financial services they offer, some having to do with longer term asset planning. And, look for companies that help you get educated on the finer points of what they do, and those finer points impact you.
Also, spend time gaining an understanding of how the exchange funds are managed. The proceeds of sales from the relinquished property go to the QI and are held until the purchase of the new property. In some cases, these funds are invested, rather than put into insured accounts. It is important to know how those funds are invested and specifically, how risky those investments are. Continue to ask questions about this subject until you are satisfied that the risk is something you are comfortable accepting.
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