Sec 1031- Like Kind Exchange as a Tax Deferment Strategy- Paper 2

Sec 1031 – Like Kind Exchange Paper # 2 is in continuation to Paper # 1 which was also on Sec 1031- Like Kind Exchanges. The latter can be found on my website at www.gavtax.com and also on my Facebook and Linkedin pages.

In the first paper, the definition, benefits, eligibility, what types of properties qualify and which do not, deadlines and the form to be used for a Like Kind Exchange were discussed.

Some of the other common questions are addressed below:

What are the different types of a Sec 1031 – Like Kind Exchange?

In order for a Like Kind exchange to happen, there should be an exchange of properties.

The simplest type of exchange is a simultaneous swap of one property for another.

On the other hand, in a deferred exchange, the disposition of the relinquished property and acquisition of the replaced property are mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers using the deferred exchange option generally use intermediaries or facilitators under exchange agreements pursuant to rules given under the Income Tax Regulations.

A third type of exchange which is called the reverse exchange is complex than the previous two exchanges mentioned earlier. A reverse exchange occurs when the taxpayer acquires the replacement property before transferring the relinquished property. In other words, the property is bought first and exchanged later. Reverse exchanges are usually cash based and loans are therefore difficult to come by.  As an example, the taxpayer has 45 days to identify what is being sold as relinquished property and has another 135 days to complete the sale of the identified property and close the reverse Sec 1031 Like Kind exchange.

Lastly, there is also a Constructive or Improvement Exchange where the taxpayer makes improvements on the property while it is still in the hands of a qualified intermediary. The tax deferred dollars that the taxpayer saves from the exchange are generally used and he has approximately 180 days to complete the fixtures and improvements on the relinquished property.

Role of a qualified intermediary

A qualified intermediary sells the property on taxpayer’s behalf, buys the replacement asset and then transfers the deed to the taxpayer.

Part of a qualified intermediary’s responsibilities is to hold the proceeds and the property itself, prepare the legal documents, and try to ensure that the transaction is completed as per IRS guidelines. There is a written agreement between the taxpayer and the qualified intermediary which is executed before closing on the sale of the existing property. This preserves the tax deferral benefits and completes a successful 1031 exchange. Some of the roles and responsibilities of a qualified intermediary go as follows:

• Is required to coordinate with the taxpayer’s attorney or advisor and provide exchange transaction documentation as needed so that the 1031 exchange rules and regulations are thoroughly read and understood.
• He prepares the necessary exchange documentation which includes exchange agreement, assignment agreements, notice of assignment, exchange account forms, security of funds instruments (when applicable) and instructions to the closing officers.
• He helps facilitate the sale of the relinquished property to the buyer and the purchase of the replacement property from the seller;
• He holds and protects exchange proceeds on behalf of the taxpayer until exchange funds are needed to purchase the replacement property;
• Is required to provide guidance, information and critical timelines throughout the entire 1031 exchange process.

Related party transactions

Related party 1031 Exchange transactions occur when a taxpayer buys or sells property from or to a related party. Specific rules and guidelines issued by the Internal Revenue Service need to be followed in order to allow related party transactions. If the related party relationship is eliminated prior to structuring and completing the 1031 Exchange transaction, related party issues can most certainly be avoided.

Sections 267(b) and 707(b) of the Internal Revenue Code define related party transactions in context to Like-Kind exchanges. Related parties include, but are not limited to, immediate family members, such as sisters, brothers, spouses, ancestors and lineal descendants.  Related parties do not include stepparents, uncles, aunts, in-laws, cousins, nephews, nieces and ex-spouses.

Corporations, limited liability companies(LLCs) or partnerships in which more than 50% of the stock, membership interests or partnership interests, or more than 50% of the capital interests or profit interests, is owned by the taxpayer is considered to be a related party.

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