Exchange Guidelines

Internal Revenue Code Section 1031

1031 Exchanges are no mere “loop-hole” in the tax code. Tax deferred exchanges have been a staple of Internal Revenue Code since the 1921. IRC §1031 provides that:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Like Kind Property

In order for a property to be included in a tax deferred exchange, it must be held for “productive use in a trade or business or for investment.” Both the relinquished property and the replacement property must be held for this purpose. Property held purely for personal use, such as a primary residence will not qualify for tax deferral under IRC §1031. However, with regard to real property, the relinquished property and the replacement property do not have to have the same use. An office building can be exchanged for a factory, which can be exchanged for a single family rental condominium, or even a leasehold interest with at least 30 years remaining in the term, including renewal options. So for real property, the definition of “like kind” is very broad, as opposed to personal property, where the assets must generally be in the same asset class in order to be exchanged, i.e. a computer for a printer, or a crane for a tractor.

Exchange Required

In a 1031 Exchange, it is not enough to just sell one property and buy another property. The two properties must be exchanged. This can be done by two parties trading properties by simply swapping deeds, provided that the properties are of the same value and neither property is encumbered by mortgage debt.

Such transactions are exceedingly rare, but the Treasury Regulations permit a more convenient structure: the Qualified Intermediary Safe Harbor. It permits non-simultaneous exchanges involving multiple parties, so that the transaction need not be a direct swap. The Exchanger can sell their relinquished property from one party, and buy their replacement property from another party.

For tax purposes, the Exchanger essentially “swaps” properties with a Qualified Intermediary. The Exchanger gives their property to the Qualified Intermediary, who then sells it to a third-party. With the proceeds from the sale, the Qualified Intermediary then purchases a Replacement Property and gives it to the Exchanger, completing the swap.

Because it would be cumbersome to actually transfer the properties through the Qualified Intermediary, which would require multiple deeds to be recorded, possibly resulting in additional closing costs and potential liability, the Treasury Regulations permit “direct deeding” of the properties from the respective Seller and Purchaser of each property. Instead of the Qualified Intermediary receiving title to the properties, it is sufficient if the Qualified Intermediary is assigned the Exchanger’s rights under the contracts of sale, and receives the net sales proceeds from the closing of the relinquished property, in order to prevent receipt or constructive receipt of those funds by the Exchanger.

Qualified Intermediary

What exactly is a Qualified Intermediary? Most people are surprised to hear that no special training or licensing is required to be a Qualified Intermediary. A Qualified Intermediary essentially can be anyone who is not the Exchanger or a “disqualified person”.

A disqualified person is anyone who has acted as the agent of the Exchanger in the two years prior to the sale of the Relinquished Property, including, the Exchanger’s:

  • 1.Employee
  • 2.Attorney
  • 3.Accountant
  • 4.Investment banker or broker
  • 5.Real estate agent or broker
  • 6.Relative or other related party
  • 7.A corporation or partnership in which the Exchanger (or other disqualified person) owns more than a 10 percent interest

Since almost anyone can be a Qualified Intermediary, it pays to choose one you can trust. KV 1031 has the knowledge and experience to make your 1031 exchange a smooth and seamless transaction. As part of the Kensington Vanguard family, you can rest assured that your funds are safe and secure with KV 1031.