IRC 1031 DEFERRED EXCHANGE – WHAT HAPPENS?
The following outline is based on the Final Regulations that were issued by the IRS on April 26, 1991
Two Types of Deferred Exchanges
Delayed Exchanges – the most popular method of completing a Deferred Exchange and the method discussed in this outline.
Professional Intermediary such as Brass Tax Exchange, Inc. is used. Competent and informed about the rules and regulations involved in handling deferred exchanges.
Not as popular a method of completing a Deferred Exchange.
- Requires same title and escrow holder (due to collected funds regulations)
- Seller of Replacement Property acts as Intermediary and is substituted into the sale transaction as the Seller for the Relinquished Property.
- 3. Professional Intermediary such as Brass Tax Exchange, Inc. can be used to limit the drawbacks of having individual act as the intermediary.
PARCEL I – “RELINQUISHED PROPERTY” (can include multiple relinquished properties)
A. Taxpayer’s intent to exchange – declare as often as possible
- The listing agreement
- The purchase agreement
- The escrow instructions
B. Taxpayer decides on his “Qualified Intermediary” – as soon as possible
1. What is a Qualified Intermediary?
- Facilitates completion of IRC 1031 Exchange
- Has an Exchange Agreement setting forthall the terms, conditions and duties of the intermediary while holding taxpayer’s funds
- Charges a fee for services rendered
2. Who can be a Qualified Intermediary?
A qualified intermediary is a person who is not the Taxpayer or a related party and who acts to facilitate a deferred exchange by entering into an exchange agreement with the taxpayer for the exchange of properties.
Corporation versus Individual
- A Corporation acting as an intermediary is an on-going entity that will not be affected by the change or death of the person that conducts the business of the corporation
- An individual acting as an intermediary can become subject to estate laws if death should occur during the exchange period.
3. Choose Intermediary Carefully
- No controls in California – some states have started regulating
- No guarantees; Only real assurances are intermediary’s reputation and the Exchange Agreement.
- Notify your Escrow Holder immediately of the Intermediary you choose.
- Escrow Holder will need to provide Intermediary with escrow instructions and a preliminary title report covering the relinquished property.
- Purchase money notes generated in the Parcel I escrow – it is important to have the Taxpayer advise as soon as possible what to do with purchase money paper, if it is part of the Relinquished Property transaction. This is where it is very important to have tax accountant/attorney opinions.
- Installment sale treatment of new purchase money
a.) For an installment sale treatment of the note and trust deed the following procedure may be considered: When creating the purchase money note and trust deed the Intermediary is the Trustor (remember that the Intermediary has been substituted in place of the Seller/Taxpayer) and the Intermediary is the maker/trustor
- Now the note can be assumed by the Buyer of the replacement property and executes an Assumption and Release of Liability that releases the Intermediary of the obligation to pay the note.
c. The Seller/Taxpayer remains unchanged as the Beneficiary which meets the test that the Seller taxpayer intended to keep the purchase money note and trust deed as an installment sale.
2. Options for the note and trust deed – the Intermediary is the Beneficiary of the note and the Buyer of the relinquished property is the trustor.
- Can be held by Intermediary during the exchange period and then assigned to Seller/Taxpayer during the exchange period – may then be taxable as boot.
- Sold during the exchange period and the funds received by the Intermediary become part of the taxpayer’s account.
3. Can be used as part of the purchase price of the Replacement Property if the seller of that property agrees to accept the note as part of the contract.
- Installment sale treatment of new purchase money
- Intermediary will be asked to provide the following to the Escrow Holder:
- “Substitution of Seller Amendment” – this amendment to the relinquished property takes out the Seller/Taxpayer and substitutes in the Intermediary as the seller. This amendment provides for the payment of the fee and also for the delivery of the net proceeds to the Intermediary at the close of escrow.
- Articles of Incorporation and a copy of the Corporate Resolution that allows the Intermediary to acquire and transfer properties and who can sign to conduct business for the corporation (only required when the Intermediary is a corporation).
- A signed and notarized grant deed from the Intermediary to the Buyer of the Taxpayer’s property if a purchase money note and trust deed are being created for an installment sale. This process is called “sequential deeding” because the deeds follow a sequence from the seller/taxpayer to the intermediary and then to the buyer of the relinquished property.
- The IRS has stipulated that deferred exchanges can be closed by a process call “direct deeding”. This is the most common practice used by all intermediaries because it allows the intermediary to handle the deferred exchange without actually taking title to the property, which further eliminates liability on the part of the intermediary for the any possible high risk conditions of the relinquished property
- At the close of escrow for the Relinquished Property the substituted Seller of the Taxpayer’s property is the Intermediary and the net proceeds check and the closing statements are handled as follows:
- Closing statement must reflect the Intermediary as the Seller. The HUD-1 can show the Taxpayer/Seller for the purposes of furnishing less confusing documentation to the Buyer’s lender.
- The net proceeds check is payable to the Intermediary (the check is either written directly to the intermediary or to an escrow for the credit of the Intermediary depending on the instructions given by the Intermediary) and delivered to the Intermediary along with a copy of the closing statement.
- After the close of escrow any check holds or refunds due from payoffs or overpayments are forwarded to the Intermediary when received by Escrow Holder.
- Funds are held by Intermediary and invested according to the Exchange Agreement or other agreements made between the Taxpayer and the Intermediary until such time as the Taxpayer directs the Intermediary to proceed with the close of the Taxpayer’s Replacement Property.
II. THE EXCHANGE PERIOD
Count exact days on the calendar, the IRS does not provide any grace periods.
A. Identification Period – beginning on the day after the date of the close of escrow of the Taxpayer’s Relinquished Property (Parcel I) and counting that day as day 1:
- Taxpayer has 45 calendar days in which to identify the Replacement Property(ies) (Parcel II).
- How to identify
- Signing Purchase Agreement
- Signing Escrow Instructions
- Letter to intermediary
- Fax to intermediary
e. See III. Below for identification of Replacement Property
2. Exchange Period – beginning on the day after the date of the close of escrow of Taxpayers Relinquished Property (Parcel I):
- 180 – calendar days from close of Relinquished Property (Parcel I) to close escrow on Replacement Property (Parcel II), or
- The due date (including extensions) for the Taxpayer’s tax return for the taxable year in which the transfer of the Relinquished Property occurs.
- Multiple Parcels in the same delayed exchange will require extra attention to these deadlines. The 45 days start with the close of the first Relinquished Property and the last Replacement Property must close within the 180 days.
- There is, also, the option of entering multiple Relinquished properties into separate deferred exchanges if the time limits are causing a problem or may not be met.
III. THE IDENTIFICATION OF THE REPLACEMENT PROPERTY
Replacement property is treated as identified for purposes of Section 1031 only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, fax’d, or otherwise sent before the end of the identification period to a person involved in the exchange other then the taxpayer or a related party.
- The replacement property must be unambiguously described in the written document.
- Legal description of street address
- Direction clearly set forth – the NE corner of an intersection
4. Replacement property must be substantially the same as that which is identified within the Identification Period.
B. The Taxpayer may identify more than one property as the Replacement Property. However, regardless of the number of Relinquished Properties transferred by Taxpayer as part of the same deferred exchange, the maximum number of Replacement Properties that the Taxpayer may identify is.
- Three (3) properties of any fair market value;
- Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of all the Relinquished properties;
IV. PARCEL II – REPLACEMENT PROPERTY
(can include multiple Replacement Properties)
- Taxpayer finds property and opens escrow. Escrow instructions should include a clause that this escrow is the consummation of the Taxpayer’s delayed/deferred exchange.
- The initial deposit into the Taxpayer’s Replacement Property escrow can be made by Taxpayer or Intermediary at Taxpayer’s option.
- Taxpayer signs escrow instructions and tells Escrow Holder the name of the Intermediary.
- Escrow Holder sends Intermediary escrow instructions and preliminary title report covering the Replacement Property.
- Intermediary should provide the following to the Escrow Holder:
- Substitution of Buyer amendment to escrow instructions, substituting the Intermediary into the escrow as the Buyer.
- A signed and notarized grant deed with a completed and signed PCOR from the Intermediary to the Taxpayer if sequential deeding is being done.
- Articles of Incorporation and a copy of the Corporate Resolution setting forth who can sign for the corporation and stating that the Intermediary can acquire and sell properties. (Only required when the Intermediary is a corporation.)
- At the close of escrow the Buyer of the Taxpayer’s property is the Intermediary and the proceeds and statements are handled as follows:
- Closing statement must reflect the Intermediary as the Buyer.
- The RESPA HUD-1 can reflect the Taxpayer as the Buyer in order to furnish the lender with a HUD-1 that matches the new loan.
- The refund/over deposit check is written to the Intermediary (the check is either written directly to the Intermediary or to an escrow for the credit of the Intermediary depending on the instruction OF the Intermediary) and delivered to the Intermediary along with a copy of the closing statement and the HUD-1.
2. COMPLETION OF THE DELAYED EXCHANGE
1. Intermediary should provide the Taxpayer with the following at the completion of the exchange:
1. Exchange Statement (combining into one statement all Relinquished Property(ies) and all Replacement Property(ies).
2. Refund of any money left in delayed exchange:
1. Refund of Taxpayer’s deposit in Replacement Property escrow(s)
2. Rents or deposits (security, cleaning, key) can be paid separately
3. Reflect any growth factor (interest) credit
4. Balance of Taxpayer’s funds (including any boot)
2. For reporting purposes the Deferred Exchange is considered opened o the date of the close of the Relinquished Property (Parcel I – or the close of the first Parcel I) and closed on the day of the close of the Replacement Property (Parcel II – or the close of the last Parcel II).
VI. SAFE HARBORS
There are four (4 ) safe harbors in the regulations. Safe Harbors may attempt to provide the Taxpayer with a certain amount of “security” concerning the funds being held by the Intermediary, without creating a circumstance that would expose the taxpayer adversely to” constructive receipt” rules. Each of these safe harbors provides that the Taxpayer’s “rights must be limited to certain specified circumstances”.
1. Obligation of taxpayer’s transferee is permitted to be secured or guaranteed by:
1. Mortgage, deed of trust or security interest in property
2. Standby letter of credit
3. Guarantee of a third party
2. Qualified “escrow” account (not clearly defined)
3. Facilitation of deferred exchange by Intermediary. Property can be transferred by a direct deed.
4. Taxpayer is permitted to receive interest or a growth factor.
1. Must be treated as interest whether it is cash or property
2. Not available to Taxpayer until the Deferred Exchange is closed.
3. Will be reported on a 1099 as interest income.
Cardinal Pacific Escrow’s Intermediary is Brass Tax Exchange, Inc.
- $750.00 – Exchange Fee (1 relinquished and 1 replacement property)
- $250.00 – for each additional relinquished or replacement property
- $300.00 – more or less for additional miscellaneous items, if required
- Interest is paid to the Taxpayer per Exchange Agreement
- Additional fees as negotiated on a case-by-case basis.
VIII. SEEK ADVICE
- Each Taxpayer should enter into a Deferred Exchange armed with the advice of his/her tax accountant and/or tax attorney.
- Include a statement to this effect that clearly states that the Taxpayer has been advised to seek the advice of their tax attorney or tax accountant in all paper work that the Taxpayer will sign. The Taxpayer need to acknowledge that they have not received advice from the Intermediary, escrow officer, Broker or Agent unless that entity is qualified to offer that advice.