REAL ESTATE INVESTMENT: Structuring the 1031 Exchange
This is a continuation of our discussion of the 1031 Exchange as a technique for deferring tax on your real estate investments. In Part I, we reviewed the basic components of the transaction. In reality, there are pitfalls at virtually every stage, so a simply overview is probably not going to be enough for you to successful bring about a 1031 exchange. The upcoming series will take a closer look at the key issues and highlight the dos-and-don’ts.
The place to start is with the sale of Property A. You should have a clear plan in mind as soon as you decide to sell one property and buy another as a replacement. There a key concept you need to understand.
Selling one property and using the money to buy another without more does not qualify for a 1031 exchange.
That is strange, right? Isn’t selling one property and using the money to buy another precisely the essence of a 1031 exchange? Well, yes, but there is a key distinction to keep in mind. In order to avoid taxable income, you need to intend to make a swap of one property for another. That is the “exchange” aspect of the program.
It is not the same thing to sell one property and later decide to use the money to buy another property as it is to make an “exchange.”
Ideally, you will do the sale and purchase simultaneously. That is the easiest way to demonstrate you are swapping one property for another. However, it may not be convenient or possible to close on the Property B at the same time as Property A. That is alright. There is some flexibility, but you should be careful.
“Control” of Sale Proceeds
If you are going to close on the sale of Property A before you close on the purchase of Property B, then you must use a qualified intermediary to hold the sale proceeds in trust. There are companies whose sole purpose is to act as a special kind of escrow agent for 1031 exchanges. Attorneys and certain trust companies may also offer the service, but beware of restrictions.
One restriction is that your qualified intermediary cannot be an attorney who has acted as your attorney within the past two years.
The funds must be kept in a trust account subject to an exchange escrow agreement.
You cannot take control of the funds, nor even have access to the funds at any time. Both the amount you paid for Property A and the equity you earned from selling Property A must be kept in trust for the purchase of Property B.
This procedure must be followed. If you access the funds – or even have the ability to access the funds – you will likely destroy the non-recognition aspect of the transaction and will have to pay the capital gains tax. Remember, you are making a swap. You don’t get to use the money—or parlay it temporarily through other investments1 and then put it towards the purchase Property B. That is not a “swap” under the tax code.
This concept is fundamental to making a successful 1031 exchange. If you make a mistake at this stage, you’re probably done. If you fail to use a qualified intermediary to escrow the proceeds from the sale of Property A, and then go on to claim a 1031 exchange, you run the risk of having the IRS challenge your position–and charge penalties when they disallow the tax deferral.
If you have any questions or doubts, contact my office or other qualified professional for guidance.
1Bell Lines, Inc. v. United States, 480 F.2d 710, 714 (4th Cir. 1973);Carlton v. United States, 385 F.2d 238, 241 (5th Cir. 1967).  As we indicated in Barker v. Commissioner, 74 T.C. 555, 561 (1980) ; Accord, Starker v. United States, 602 F.2d 1341, 1352 (9th Cir. 1979)