Steps to Begin a 1031 Exchange?

An understanding is reached between the taxpayer and the seller that the transaction is to be an exchange transaction. While it is prudent to use the language of accommodation in the agreement between the buyer and the seller, it is not mandatory.

When the contract is ready for closing, the services of a qualified intermediary is sought. The taxpayer enters into an exchange agreement with the intermediary by which the title to the purchased property is held by the intermediary until the relinquished property is sold.  The agreement normally provides for the following:

·         That the intermediary receives the proceeds from the sale of the relinquished property.

·         That the taxpayer has no access to the funds until the Exchange is completed or is terminated.

·         The time period within which the taxpayer shall identify a suitable replacement property and enter into a contract to purchase the property. This time period is subject to the 45-Day and 180- day rules.

·         That the exchange shall be completed by the intermediary transferring the title to the replacement property in favor of the taxpayer.

After the relinquished property is sold and the intermediary contracted, the taxpayer sets out to find the replacement property. The taxpayer can purchase the replacement property from a person other than the person to whom the relinquished property was sold provided a qualified intermediary is used and the timing restrictions are complied with. The proceeds from the sale go directly to the intermediary and not to the taxpayer. These same proceeds go to the seller of the replacement property when it is purchased by the taxpayer. Thus, the transaction does not generate cash for the taxpayer. Hence, it would be unfair on the taxpayer to be asked to pay tax on the gain from the sale of the relinquished property. The timing restrictions in respect of the replacement property are:

As per the 45-Day rule, the taxpayer is required to either identify the replacement property or close on the replacement property within 45 days from the date of sale of the relinquished property.  If the property is received within the said 45 days, the rule is deemed to have been satisfied. If not so, the taxpayer should send a signed identification notice to the intermediary providing a complete and clear description of the replacement property.

The 180-Day rule: According to this rule, the replacement property should be received without any exception either within 80 days from the date of sale of the relinquished property or on or before the due date of filing the tax return, whichever is earlier. The replacement property should be received should be substantially the same as the property that was identified in accordance with the 45-day rule. If the 180 day period falls on a date later than the due date for filing the tax return, the return will have to put on extension. Otherwise, the due date for filing the return will be the last day of the 180-days, even though in reality the actual number of days is less than 180.

The taxpayer is allowed to identify more than one property subject to one of the following conditions:

·         The Three-Property Rule - Any three properties can be identified irrespective of their market values.

·         The 200% rule - Any number of properties provided the aggregate fair market value of the replacement properties is not more then 200% of the aggregate fair market value of all of the relinquished properties.

·         The 95% rule - Any number of replacement properties provided the aggregate fair market value of the properties is not less than 95% of the aggregate fair market value of all replacement properties identified.