A tax deferred exchange or “like kind” exchange is a method of disposing of and reinvesting funds from investment or business-use assets while deferring capital gains and recapture taxes. To successfully complete a like kind exchange, timing is extremely important and the assistance of experienced counsel is highly recommended.
The like kind exchange benefits are created by Internal Revenue Code Section 1031. So the process is often called a “1031 Exchange”. Before discussing the basics of the transaction, it is important to understand the nomenclature. The “Exchanger” is the person or entity that is selling and buying like kind property. The property being sold is called the “Relinquished Property” and the property being purchased is the “Replacement Property”.
The exchange process has multiple steps. The first, and most important step is to select and make arrangements with a Qualified Intermediary BEFORE the sale of the Relinquished Property. A Qualified Intermediary is typically a company that is in the full-time business of facilitating 1031 Exchanges. Most Qualified Intermediaries are bonded and insured against errors and omissions and have the relevant educational background in tax and experience in like kind exchange process. The most important thing in a 1031 Exchange is that the Exchanger must not have possession or control over the funds from the sale of the Relinquished Property at any time.
The Exchanger enters into an agreement with the Qualified Intermediary, called an Exchange Agreement. The Exchange Agreement requires the Qualified Intermediary to ‘acquire’ the Relinquished Property and sell it to the buyer (although this is still done with a direct transfer from the Exchanger to the buyer) and to ‘acquire’ the Replacement Property from the seller and then transfer it to the Exchanger (again, with a direct transfer from the seller to the Exchanger). To illustrate, the exchange of real estate would never result in a deed being provided in the name of the Qualified Intermediary, as the transaction allows for a direct transfer between the Exchanger and the other parties. However, again, the most important thing is that at no point during the process does the Exchanger have the funds.
With the assistance of an attorney, the Exchanger negotiates the sale of the Relinquished Property. The sale agreement should contain language to allow for the assignment of the agreement to the Qualified Intermediary to begin the like kind exchange. At the closing on the Relinquished Property, the sale proceeds are paid directly to the Qualified Intermediary. At this point, the clock starts ticking on the 1031 Exchange. The Exchanger now has 45 days to identify potential Replacement Properties. The list of possible Replacement Properties must be unambiguous, in writing and timely provided to the Qualified Intermediary. No Replacement Properties may be identified after 45 days. The Exchanger must now purchase a Replacement Property within 180 days to complete the 1031 Exchange.
The purchase of the Replacement Property is similar to the sale of the Relinquished Property. Again, with the assistance of an attorney, the Exchanger negotiates the purchase of the Replacement Property with the appropriate language allowing for the assignment of the agreement to the Qualified Intermediary. At the closing on the Replacement Property, the Qualified Intermediary pays the exchange funds directly to the seller of the Replacement Property and the property is assigned directly to the Exchanger. The like kind exchange is now complete!
The 1031 Exchange is a powerful wealth-building tool. It is a great way to “trade up” investment properties without having to recognize capital gains and recapture taxes. For instance, selling a four-unit apartment building to buy a twelve-unit apartment building. A like kind exchange may be the perfect tax fit for you in this situation. However, it is important to have an experienced attorney assist you with the sale and purchase agreements to ensure that your like kind exchange runs smoothly.
Arenstein & Andersen Co., LPA has experience with a wide array of like kind exchange scenarios. The attorneys at Arenstein & Andersen Co., LPA are able to assist with the drafting and negotiation of agreements to facilitate your like kind exchange, work with your accountant and real estate professional to accommodate your exchange, and work with (or help you select) the right Qualified Intermediary necessary to accomplish your goals.
About Arenstein & Andersen Co., LPA
Arenstein & Andersen Co., LPA, a law firm located in Dublin, Ohio, provides comprehensive business, real estate, and tax services to individuals and businesses of all shapes and sizes.