1031 Exchange: Requirements, Restrictions and Deadlines (Part 2)

This article is part 2 of a three-part series regarding 1031 Exchanges.

By Brandon J. Leal, Esq.

A “1031 Exchange” enables an owner (“Exchanger”) of investment property to defer capital gains tax and depreciation recapture by reinvesting proceeds from the sale of investment property into other “like-kind” investment property.  Internal Revenue Code Section 1031 and associated Treasury Regulations (the “Code”), impose strict requirements for a successful 1031 Exchange, but the benefits in tax deferral are obvious, especially if the property being sold has a low basis.  Furthermore, with recent proposals from Washington, D.C. seeking to nearly double the capital gains tax rates, this opportunity may soon be far too good to ignore.

The requirements of the Code include:

• Exchanger must hold the properties for productive use in a business or for investment purposes;
• The Replacement Property must be of equal or greater value than the Relinquished Property;
• The equity of the Replacement Property must be of equal or greater value than the equity of the Relinquished Property;
• The debt held by the Replacement Property must be of equal or greater value than the debt held by the Relinquished Property; and
• The Exchanger must use a third-party to facilitate the transaction (the “Exchange Facilitator”).

One of the most important requirements for a successful 1031 Exchange requires that the Exchanger shall not receive the proceeds from the sale of the investment property that is the subject of the 1031 Exchange (the “Relinquished Property”).  Receipt of the proceeds from the sale of the Relinquished Property (the “Proceeds”) is not limited to actual receipt.  This leads to one of the greatest risks and danger zones in conducting a 1031 Exchange: the possibility of the Exchanger being deemed to have received the Proceeds through a theory of “constructive” receipt.  Failure to meet any requirement may result in immediate tax liabilities and even possible penalties.  We strongly recommend that you consult your WHP counsel and your tax advisors to ensure that you meet every requirement.

This is where the Exchange Facilitator comes in.  The Exchange Facilitator could be an escrow agent, a trustee, a qualified intermediary, or other person that holds the proceeds on behalf of the Exchanger.  The safest way to conduct a 1031 Exchange is to use a professional third-party service provider, a Qualified Intermediary (“QI”), to facilitate the process.  The use of a QI is a safe-harbor under the Code that offers protection from claims that the Exchanger was in constructive receipt of the Proceeds, which would disqualify the exchange and result in capital gains taxes being due on the sale.  WHP can work with any authorized QI and would be happy to suggest one should the need arise.  We can also recommend qualified professional firms we have successfully worked with in the past.

Furthermore, the Code contains very strict timeline and procedural requirements for a proper 1031 Exchange that must be adhered to.  These timeline and procedural requirements include:

• Exchanger must execute an Exchange Agreement with a QI prior to closing the sale of the Relinquished Property;
• Upon closing, the Proceeds must be held by the QI (Exchanger must not receive any of the Proceeds either directly or indirectly);
• Exchanger has 45 days from the day title to the Relinquished Property transfers to identify (in writing) the property that the Proceeds will be used to purchase (the “Replacement Property”):
  • Exchanger may identify up to three properties;
  • The fair market value of the properties identified may NOT exceed 200% of the fair market value of the Relinquished Property;
  • Exchanger must acquire at least 95% of the property identified;
• Exchanger has 180 days from the day title to the Relinquished Property transfers to close on the purchase of the Replacement Property.

1031 Exchanges are powerful tax planning tools and can provide great advantages to owners of investment property.  However, the requirements of the Code must be strictly complied with and any failure to do so can result in tax consequences and even penalties.  When the time comes to upgrade facilities or move into a different market, please contact your WHP counsel to see if a 1031 Exchange is an appropriate option for you.

We invite you to read other articles in this three-part series:

• Part 1:  1031 Exchange Rules: What is Qualified Like-Kind Property?
• Part 3:  1031 Exchange: Reverse Exchanges

This article provides an overview and summary of the matters described therein. It is not intended to be and should not be construed as legal advice on the particular subject.