A 1031 Tax Deferred Exchange Can Delay Payment of the Taxes Owed On the Sale and Subsequent Purchase of Business and Investment Property

Q:  I have a residence that I have been renting and I want to sell it, delay payment of the capital gain tax, and then purchase an office building.  Can I use a 1031 tax deferred exchange to delay payment of the tax I would otherwise have to pay?

A:  Subject to the extensive tax code and rules and regulations of the IRS, the use of an exchange of property under section 1031 of the tax code should be considered as a method of delaying payment of the capital gains tax owed on the proceeds of the sale of relinquished property.  However, it is a relatively complex transfer of real property that has significant tax issues, and the advice of a qualified and trustworthy accommodator should be sought before making a decision about using a 1031 tax deferred exchange.

The accommodator is an independent third party that acts as a qualified intermediary in the transaction, and it receives the proceeds from the sale of the relinquished property.  The accommodator should be carefully chosen because the accommodator is responsible to hold the sale proceeds in trust in its own bank account for the “exchangor”, the person performing the exchange.  The sums held by the accommodator can be substantial, and there has been fraud by dishonest persons acting as accommodators.

One of the main considerations when selecting the accommodator should be the amount of its fidelity bond and any errors and omissions insurance.  Any reputable accommodator would be happy to provide proof of its bond and insurance limits, and evidence that they are current.  Beware of the person who does not provide evidence of a bond or insurance, or produces doubtful evidence that they are real and current.  Unlike other professions in property transactions such as attorneys, certified public accountants, and real estate agents and brokers, accommodators are not licensed by the State of California, and there are no minimum standards of conduct.

Other considerations in selecting the accommodator should be whether it can provide tax advice regarding the transaction.  Only a tax professional such as a CPA or attorney can lawfully give tax advice, and such advice is often essential to maximize the tax benefits of a 1031 exchange.  Also, if there is an inquiry by the Internal Revenue Service, the accommodator should be able to explain why the exchange complied with the tax code and IRS requirements.

The accommodator cannot be a relative of the exchangor or someone who has had a financial relationship with the exchangor during the two years prior to the close of the escrow for the sale of the relinquished property.  The accommodator is similar to an escrow company because it is supposed to be independent of the exchangor.

There are two types of property in a 1031 exchange, the relinquished property and the replacement property.  The relinquished property is the real or personal property owned by the exchangor, who can be a person, partnership or corporation that has ownership of the property and wants to sell it and use the proceeds to purchase the replacement property.

The replacement property is a separate “like kind” property that must be identified within 45 days after the close of the escrow for the sale of the relinquished property, and the proceeds must be transferred within 180 days from the close of escrow of the relinquished property.  It is always a good idea to have performed sufficient investigation to locate the replacement property as soon as possible after a decision is made to use a 1031 exchange so that the 45 day requirement can be met.  Like kind means the relinquished and replacement property must both be real property, or both personal property.  Real property cannot be exchanged for personal property, or vice versa.

A 1031 exchange can only be used if both the relinquished and replacement properties are held for investment (rental income or unoccupied) or for productive use in a trade or business (office building).  There must be a reciprocal transfer of properties by deeds, and the replacement property cannot be used as a residence.

During the escrow for the sale of the relinquished property, a copy of the escrow instructions and a preliminary title report are sent to the accommodator who then prepares the exchange documents.  After the escrow closes on the sale of the relinquished property, the net proceeds are sent to the accommodator who informs the exchangor of the 45th and 180th days from the close of escrow.

After the replacement property is determined, a new escrow is opened that must be closed within 180 days after the close of the first escrow.  In order to defer all capital gain taxes until after the eventual sale of the replacement property, all of the net proceeds held by the accommodator must ordinarily be used to purchase the replacement property.  Also, a mortgage on the replacement property must be equal to, or greater than, the prior mortgage on the relinquished property.

Another type of exchange is a reverse exchange that is used when the replacement property is acquired before the relinquished property is sold or before a buyer of the relinquished property is determined.  Another type is a build to suit exchange that is used to improve the replacement property after it is purchased.

A 1031 tax deferred should be considered whenever an owner wants to sell investment property, real or personal, and then purchase like kind investment property, while minimizing the capital gain taxes that would otherwise be owed upon the sale of the relinquished property.  Selection of a qualified and trustworthy accommodator is a critical factor to insure that the exchangor realizes the maximum benefit with the least risk during the exchange.

The opinions expressed in this article are those of the author and not the Daily News, and they do not create an attorney-client relationship or constitute legal advice.  Individual circumstances may vary and professional advice is recommended before making any decisions concerning legal matters. 

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