IRC 1031 Tax Deferred Exchange

Julie Bratton is the Vice President & Regional Sales Executive at Old Republic Exchange and has overseen its tax-deferred exchange department since 2001.

With 27 years of experience in the industry, she successfully manages the department’s staff, marketing initiatives, and educational program.

She received a Bachelor of Arts/Sciences in Architecture & Interior Design from SDU and previously was a sales and marketing consultant at Old Republic Title & Escrow of Hawaii.

The IRC 1031 Tax Deferred Exchange provides that in order for an individual to qualify for a tax deferred treatment, the property to be relinquished must be exchanged for a replacement property that is of like kind.

Like kind is understood as something that is similar in nature and character. The fact that any real estate involved is improved, or unimproved, is not material for that fact relates only to the grade or quality of the property and not it's kind or class.

For example, vacant land being held for investment may be exchanged for single-family rentals used for a trade, business, or any combination of the following: commercial, farms, golf courses, hotels, industrial, motels, single/multi-family rentals, office, ranches, retail, and land.

Approved Settlement Fees

A major issue arises when the Exchanger is selling their relinquished property and they use Exchange Proceeds to pay off either expense incurred for the exchange, known as settlement fees.

When an expense is paid for, the Exchanger using sales proceeds reduces the amount that is sent to the Exchange account. If the expense is allowed to be paid with the proceeds it does not cause a problem, but if the expense is not allowed it causes a taxable event.

Exchange expenses allowed to be paid for with exchange funds: accommodator fees, document preparation fees, escrow fees, finders fees, legal fees, loan payoff, messenger fees, notary fees, processing fees, sales commissions, and transfer taxes. (1031_exchange_expenses.pdf)

The following is a list of non-exchange expenses which should be paid for with outside funds, or it may be considered boot: homeowners dues, property liability insurance, property taxes, rent prorations, repairs, replacement property loan acquisition fees, termite treatment, and utilities.

Delayed Exchange

The most commonly utilized tax planning strategy available to investors is the Delayed Exchange, or Starker Exchange. A Delayed Exchange occurs when there is a time delay between the sale of the relinquished property and the purchase of the replacement property.

This exchange provides real estate investors up to 180 days to purchase a replacement property once their relinquished property has closed escrow. In order for this to be a valid exchange, a QI is required to facilitate the process. The Delayed Exchange occurs in three steps:

1. Before closing on the sale of the relinquished property the Exchanger retains a Qualified Intermediary who prepares an exchange agreement, assignment of sale contract, and closing instructions to the escrow agent. The QI instructs the escrow agent to direct deed the relinquished property to the buyer and to deliver sale proceeds directly to the exchange company.
2. The Exchanger must identify the replacement property within 45 days of the close of escrow. The identification of the exchange property is valid only if the replacement property is designated as replacement property in a written document signed by the Exchanger and delivered to the seller of the replacement property. Either one of these three identification rules will apply: 1) the 3 property rule wherein three properties must be identified no matter what the fair market value; 2) the 200% rule where any number of properties as long as the aggregate fair market value does not exceed 200% (2x) of the fair market value of all the relinquished properties; 3) the 95% rule where any number of properties without any regard to value, providing 95% of the value of the identified properties are acquired.
3. Within 180 calendar days from the sale of the relinquished property, the Exchanger must acquire a replacement property and the property acquired must be one or all of the previously "identified" replacement properties.

Reverse Exchange

A Reverse Exchange occurs when the acquired replacement property occurs prior to the sale of the relinquished property. The Exchanger utilizes the Qualified Intermediary "QI" to purchase the replacement property and hold title while the Exchanger markets the relinquished property. The Reverse Exchange must be completed within 180 days, as done with the Delayed Exchange. There are two types of Reverse Exchanges:

1. The Exchange Last version occurs where the title to the replacement property is parked with the exchange accommodation titleholder. The Exchanger then enters into a written agreement with the EAT who then acquires title to the replacement property and holds it until a buyer is found for the relinquished property. Once this property is ready to close escrow, the titleholder then enters into a simultaneous exchange with the Exchanger, thus transferring the title to the replacement property to the Exchanger in exchange for causing the transfer of the relinquished property to a third-party buyer.
2. The Exchange First is where the QI acquires the right to purchase the replacement property and causes it to be deeded directly from the seller to the Exchanger in exchange for the Exchanger's transfer of the relinquished property to the exchange accommodator. The relinquished property is held until a buyer is discovered. Once this occurs, the relinquished property is then sold to the third-party buyer by the exchange accommodator.