Whenever you sell an investment property and have a gain, you usually pay a tax on the gain at the time of sale. However through Section 1031 Like-Kind Exchange and exception allows the buyer to delay paying the tax on the gain until a future date if the gain is reinvested in similar property or "like-kind". Strict compliance with applicable IRS rules is required to utilize this powerful tax deferral tool.
Theory Behind Section 1031
The theory behind Section 1031 is that when a property owner sells one property (relinquished property) and reinvests the sale proceeds into another property (replacement property) the economic gain has not been realized in a way that generates funds to pay any tax.
In other words, the taxpayer's investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). The use of this method to postpone taxes is not limited to real estate but can also be used with personal property such as business equipment (e.g. crane exchanged for another crane, airplane for another airplane, etc.).
Exchange One Property for Another at the Same Time
The simplest type of exchange is a simultaneous exchange, which is when the exchange of one property for another happens at the same time. The most common type of exchange because of its flexibility is a delayed exchange, which is when there is a time gap between the exchange of the properties (the properties are not exchanged simultaneously). Most like-kind exchanges are accomplished through the utilization of a section 1031 Qualified Intermediary.
Qualified Intermediary for Tax Deferred Exchange
A section 1031 Qualified Intermediary is an independent and professional facilitator who receives the funds from the original sale and holds the funds until they are used to purchase the new exchange property.
The Qualified Intermediary will typically perform the following services:
- Coordinates with the exchangers and their advisors to structure a successful exchange.
- Prepares the documentation for the Relinquished Property and the Replacement Property.
- Provides escrow services with instructions and documents to effectuate the exchange.
- Secures the funds in an insured bank account until the exchange is completed.
- Provides documents to transfer Replacement Property to the exchanger and disburses exchange proceeds to escrow.
- Holds the document of identification of Replacement Properties sent by the taxpayer.
- Submits a full accounting of the exchange funds for the taxpayer?s records.
- Submits a 1099 to the taxpayer and the IRS