The execution of a 1031 exchange is a complicated process, and the IRS rules are strict. The investor can manage parts of the transaction, but not others, and it would be wise to have guidance for the overall scenario. How much of the planning and selection you can handle on your own partially depends on your skillset.
A 1031 exchange is a way of deferring the recognition of capital gains taxes on the sale of a real estate asset. The taxpayer accomplishes this by "exchanging" the proceeds from the sale of one investment property into a "like-kind" property of equal or greater value, also held for investment or business use. The IRS has been generous in interpreting "like-kind" as long as the original and replacement assets are both investment assets. However, the rules regarding the value of the replacement and the timeline for identification and acquisition of replacement are not flexible.
The Investor Provides the Overall Direction
Without question, you determine the direction and decide to defer the recognition of the capital gain by completing a 1031 exchange. Your investment advisor can undoubtedly suggest this course, but the strategy choice is yours. Some prefer to pay taxes as they go along or to avoid selling to sidestep the issue altogether.
The Use of a Qualified Intermediary is Required
While an investor can choose which property to sell (exchange) and identify replacement properties, the investor/taxpayer may not control or have access to the funds in between those two events. For that reason, the use of a qualified intermediary is necessary. That requirement eliminates the ability of an investor to complete a 1031 exchange without assistance.
The qualified intermediary cannot be the investor and cannot work for, be related to, married to, or an agent of the investor. The qualified intermediary can be a person or a company, must be a neutral party (so can't be the seller of the replacement property or buyer of the relinquished property), and must hold the relevant funds in an account that the investor cannot access.
What Does the Qualified Intermediary do for the Investor?
Besides holding and safeguarding the funds, the qualified intermediary formally receives the identification of the replacement properties within 45 days of the relinquished property sale. Other duties include:
- Coordinating with the taxpayer on the structure of the 1031 exchange.
- Providing escrow instructions for all involved transactions.
- Creating an arms-length transaction between the taxpayer and the buyer and sellers.
- Transferring the property to the QI, then to the buyer.
- Acquiring the replacement property or properties and then transferring title to the taxpayer within 180 days of the relinquished property sale.
- Creating a thorough accounting of the transaction.
How is a Qualified Intermediary Paid for their Work?
Since the qualified intermediary must remain independent, they are frequently paid a flat fee for their service. Some are compensated by using the interest on the accounts in which they retain the proceeds and charging fees for the administrative functions of document preparation. Each taxpayer and intermediary can agree to the terms they prefer. Since a qualified intermediary cannot provide other services to an investor (such as legal advice, investment, or accounting services), the provision of such services cannot be bundled.
The 1031 Investor's Guidebook
Tackle the art and science of completing your 1031 exchange.