1031 Exchange Frequently Asked Questions
What is the statutory basis for Sec. 1031 exchanges?
Generally, Section 1001 (c) of the Internal Revenue Code of 1986, as amended (the “Code”) provides that a taxpayer must recognize gain or loss on the “sale or exchange” of property. As a result, the taxpayer is subject to capital gains tax on any realized gain arising out of the sale of real estate held by the taxpayer for business or investment purposes.
However, §1031 of the Code represents one of the last legitimate tax shelters available to owners of real estate; §1031 provides a vehicle to allow real estate owners to defer payment of capital gains tax by reinvesting net sales proceeds derived from the sale of property to a third party (the “relinquished property”) in the purchase of similar real estate (the “replacement property”).
What role does the Qualified Intermediary play in a Sec. 1031 exchange transaction?
In order for a taxpayer to successfully complete a §1031 tax deferred exchange, it is vitally important that the taxpayer does not receive, actually or constructively, any money or other property before the taxpayer receives its like kind Replacement Property. If the taxpayer does actually or constructively receive money from the sale of the Relinquished Property before it receives the like kind Replacement Property, the transaction will constitute a taxable sale, and will not qualify for nonrecognition treatment. For purposes of evaluating whether a taxpayer is in actual or constructive receipt of money prior to its receipt of like kind Replacement Property, one must determine whether the taxpayer has the right to control or take possession of the funds at will, or whether certain limitations on its ability to control or access the funds lapse, expire or are waived.
In order to ensure that the taxpayer does not receive the net proceeds of the sale prior to the receipt of the Replacement Property, §1031 and its regulations provide four safe harbors. The safest and most often used sale harbor provides for the use of a qualified intermediary to hold the net sales proceeds until the replacement property is purchased. As long as the qualified intermediary holds the funds during the pendency of the exchange, and the taxpayer does not have actual or constructive control or possession of such funds, the taxpayer will not be held in constructive receipt of such funds so as to invalidate the exchange.