Whenever you sell business or investment property and have a gain, you generally have to pay tax on the gain at the time of sale. Internal Revenue Code (IRC) Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
To plan for a successful 1031 exchange the following are initial steps that will be helpful in the process of the closing transaction that involves a property exchange. It is also crucial to engage a real estate attorney who is proficient in these matters.
1) After entering into a purchase and sales agreement, the seller will need to advise the agent of who they intend on using to do the exchange. It is important to notify all the parties that will participate in the closing transaction as an Escrow Agreement, Assignments, and other pertinent documents must be prepared and executed prior to closing on the property being sold.
2) Instruct the agents to include an “Exchange Cooperation Clause” in the purchase and sales agreement.
Relinquished Property Sales Contract:
“Notwithstanding anything to the contrary, Buyer hereby acknowledges that it is the intent of the Seller to effect an IRC 1031 tax deferred exchange, which will not delay the closing or cause additional expense to the Buyer. Seller’s rights under this agreement may be assigned to the “Exchange Company” as the Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with Seller and the “Exchange Company” in a manner necessary to complete the exchange.”
Replacement Property Purchase Contract:
“Notwithstanding anything to the contrary, Seller hereby acknowledges that it is the intent of the Buyer to effect an IRC 1031 tax deferred exchange, which will not delay the closing or cause additional expense to the Seller. Buyer’s rights under this agreement may be assigned to the “Exchange Company” as Qualified Intermediary, for the purpose of completing such exchange. Seller agrees to cooperate with Buyer and “The Exchange Company” in a manner necessary to complete the exchange.”
It is also important in a 1031 Exchange that the client who relinquished property starts the search for the replacement property immediately to insure that they can meet the strict time frame for the 45 day identification period.
It is also important that the client understands that any Qualified Intermediary involved does charge a fee for the exchange and the fee varies. To learn more about a 1031 exchange, reach out to a tax professional or a real estate attorney to assist in the process.