A 1031 tax exchange can be used to defer taxes on your real estate investment property, provided that your properties qualifies for a 1031 exchange. It’s also important to understand the process in detail, of how a 1031 tax exchange works. Here is a step by step guide to the process:
Step 1. Hire and retain a tax counsel or certified public accountant.
Step 2. Sell the real estate property, and execute the Cooperation Clause in the sales agreement: "Buyer is aware that the seller’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer." Your escrow officer must contact the Qualified Intermediary at this point to order and secure the exchange documents.
Step 3. At his point you enter into the 1031 tax exchange agreement with your Qualified Intermediary. In this setup, the Qualified Intermediary is named as principal in the sale of your sold property and the subsequent purchase of your replacement (new) property. The 1031 Exchange Agreement must meet with IRS Requirements, especially pertaining to the proceeds. Along with said agreement, an amendment to escrow is signed which so names the Qualified Intermediary as seller. Normally the deed is still prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.
Step 4. After this point, the relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to your Qualified Intermediary (QI). The funds now should be secured in a separate market account to ensure safety and that the funds are liquid and available. It is important to keep these funds separate so they are available. The closing date of the relinquished property escrow is considered to be Day 0 of the exchange, and that’s when the exchange clock begins to tick. Written identification of the address of the replacement property should be sent within forty five days and the identified replacement property must be acquired by the taxpayer within 6 months (180 days to be exact).
Step 5. Written identification of the address or legal description of the replacement property at this point should be sent by the taxpayer to the Qualified Intermediary, on or before Day 45 of the exchange. It should be signed by everyone who signed the exchange agreement, and it may be faxed or hand delivered or even physically mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney. Send it via certified mail, return receipt requested. You will then have proof of receipt from a government agency.
Step 6. At this point, you enter into an agreement to actually purchase replacement property, which includes the followingCooperation Clause: "Seller is aware that the buyer’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to co-operate with the buyer to accomplish same, at no additional cost or liability to seller." An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.
Step 7. After all of these conditions have been satisfied and the escrow is prepared and ready to close and prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary then forwards the exchange funds and growth proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.
Step 8. After the close, you file form 8824 with the Internal Revenue Service when taxes are filed, and whatever similar document your particular state requires.
That is the complete process in detail from start to finish of a 1031 tax exchange transaction.
