The following is an explanation of the step-by-step process that a taxpayer and their qualified intermediary need to follow to complete a basic 1031 exchange. for more complex exchanges feel free to browse our library or give us a call at 1-800-795-0769.
1. Prior to Closing of the Relinquished Property
The IRS regulation requires that the exchange documentation be in place prior to the closing on the relinquished property, the property being sold. After determining how much capital gain you will have and how much tax you will have to pay if you do not do an exchange, then the first step is to:
A. Add a Relinquished Property Addendum to the contract you accept for the sale of the property. This addendum, while technically not required, is suggested to show the intent to do an exchange, permit assignment of the contract to the qualified intermediary, and to state there is no expense or liability for the buyer.
B. Once the exchanger has a ratified contract on the property being relinquished, then a copy of the contract must be provided to the qualified intermediary, along with the name and phone number of the settlement agent/attorney, title company or escrow agent who will conduct the settlement.
C. The qualified intermediary then prepares the required Exchange and Escrow Account Agreement, the Assignment of Contract, the Notification of Assignment to all parties to the contract, and instructions to the settlement agent/attorney. These documents must be signed and delivered prior to the settlement.
2. After Closing of the Relinquished Property
The settlement agent/attorney wires the funds to the qualified escrow account established by the qualified intermediary, along with a copy of the settlement statement and the exchange fee.
3. 45-Day Identification
Within 45 days of the transfer of the first relinquished property, the exchanger must provide an identification of the potential replacement property(ies). The regulation provides different identification options. One is that if the replacement property is received before the end of the 45-day identification period, it is considered identified. A second, more common method, is to identify no more than three alternative properties with any fair market value before the end of the 45-day identification period. The third method is to identify more than three properties whose total fair market value does not exceed 200% or twice the value of the property relinquished.
The IRS regulations require the identification of replacement properties be in writing, be signed by the exchanger, and be delivered to a party to the contract who is not disqualified. Most exchange agreements require it to be delivered to the qualified intermediary.
Properties should be identified by street address and/or legal description.
** IMPORTANT RULE** After the 45-day period only those properties identified may be purchased as replacement properties and be part of the exchange. No new properties may be identified after the 45-day identification period.
An identification may be revoked any time during the 45-day identification period and a new replacement property identified. Remember, this also must be done in writing, be signed by the exchanger(s) and be delivered to the qualified intermediary before the end of the identification period.
Identification of Property to Be Built
The regulations provide special rules for the identification and receipt of replacement property to be built. The identification requirement for the property to be built will be met if the identification provides “a legal description for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made.”
Note: Improvements to be made to property already owned by the exchanger are not considered like-kind and cannot be used as a replacement property.
4. The 180-Day Exchange Period
Once the replacement property has been identified, you have 180 days from the transfer of the first relinquished property to settle on the replacement property(ies) of your choice. This is 180 days or, if earlier, the federal tax due date including extensions for the tax year the relinquished property was transferred.
5. Prior to Transfer of the Replacement Property
When a contract offer is made on a desired replacement property, it is suggested that a Replacement Property Addendum be added which states that the transaction is part of a like-kind exchange, that the contract may be assigned to the qualified intermediary, and there is no liability or expense to the sellers.
Once the qualified intermediary receives a copy of the contract to purchase the replacement property, then the required Assignment of Contract, Notification of Assignment and instructions to the settlement agent/attorney may be prepared. Prior to settlement the qualified intermediary wires the exchange escrow funds to the settlement agent/attorney.
6. After Settlement of the Final Replacement Property
After the qualified intermediary receives the settlement statement for the final replacement property, they may pay any interest that has been earned and return any excess escrow funds.
7. Reporting the Exchange – IRS Form 8824
As part of the tax return for the year that the relinquished property was transferred, the exchanger will report the exchange on IRS Form 8824, Like-Kind Exchange. Visit our Form 8824 help page for a free copy of: Form 8824 Workbook.
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