The property being purchased in the 1031 exchange from proceeds of sale of relinquished property.
The property being sold in a 1031 exchange of which one is transferring gains from.
Everything of value other than the like-kind exchange property which you receive during an exchange. Any cash that is received would be considered as “boot.” It would be taxable to the extent of gain “realized.”
For investment property to qualify under section 1031, the properties exchanged must be of “like kind,” which means that they are of the same nature or character, even if they differ in quality. They must be held for a productive purpose in a business or trade, such as for investment.
“Like-kind exchange” does not mean “identical.” For example, single family homes can be exchanged for apartments, office buildings can be exchanged for warehouses or land, etc.; these are all various forms of investment real estate and are considered like-kind. But personal property, such as machines or equipment, is not considered real property and is not like-kind for the purpose of doing a 1031 exchange with investment real estate.
The property being sold in a 1031 exchange is known as the relinquished property, and the property being purchased in the exchange is called the replacement property. It is acceptable for either the relinquished and/or replacement property to be multiple properties, as long as their aggregate values are considered for the exchange. For purposes of the ensuing discussion, “property” will be used to indicate either one or multiple properties.
Under the 1031 exchange rules, the proceeds from the sale of the relinquished property must be handled by a third party qualified intermediary (QI), sometimes known as an exchange facilitator or exchange accommodator. The proceeds from the sale must never be in the possession of the investor or their agent, or the 1031 exchange will be considered invalid. The QI cannot be a person or entity with whom the investor has had a family or prior business relationship.
A QI is an independent organization whose only relationship with the investor is to handle the exchange transaction funds on the investor’s behalf. The QI’s duties on behalf of the investor include:
- Receiving the proceeds from the sale of the relinquished property and holding them in escrow.
- Disbursing the proceeds for the replacement property on behalf of the investor.
- Managing the 1031 exchange process on behalf of the investor to ensure the 1031 exchange is in compliance with the IRS code, including all of the paperwork and meeting the timing deadlines.
- The QI can perform all of their duties without ever taking title to the properties involved in the 1031 exchange transaction.
A good QI typically specializes in 1031 exchange transactions and should be adequately bonded and insured. They make their money by charging transaction fees to the investor and/or by retaining the interest on the funds that are held on behalf of the investor.
It is strongly recommended that choosing a good QI be the first step taken by an investor contemplating a 1031 exchange, even before listing the relinquished property for sale. The QI can explain in detail the entire process and 1031 tax exchange rules, validate that the transaction being contemplated is eligible for a 1031 exchange, ensure that all of the rules are complied with and that all of the required paperwork is in order. Because a 1031 exchange is governed on U.S. federal tax law, it is not important that the QI be in the same state as the investor. All of the transactional details can be handled by online and by phone. The Federation of Exchange Accommodators is the professional trade association for 1031 exchange QI’s for and is a good place to find them.