How a 1031 Exchange WorksUtilizing a Real Estate Investment for Passive Income

Step 1: IRC section 1031

Section 1031 of the Internal Revenue Code permits investors to defer the payment of tax on the gain from the sale of property held for productive use in business, trade or investment, provided that the property is exchanged for a “like kind” asset or assets. The section creates a “safe harbor” that permits the taxpayer to have assurance that the transaction will permit the deferral of the capital gain tax payment.

Step 2: Select a Qualified Intermediary.

The IRS requires that the proceeds from the sale of the property (the “relinquished property”) be held by a Qualified Intermediary (a “QI”) until the replacement property is purchased. The taxpayer must assign to a QI their interest as seller of relinquished property.

An “exchange agreement” is executed between the taxpayer and e1031xchange.

Step 3: Include the exchange cooperation clause as an addendum to contract.

It is important to include language in the contract of sale for both the sale of your relinquished property and the purchase or your replacement property that requires the counterparty to cooperate in the exchange. Typically this is not controversial, as the entire exchange is transparent to your buyer or seller, and there are no delays or costs to them in cooperating.

Here is a sample clause: “Buyer hereby acknowledges that it is the intent of the Seller to effect a Section 1031 tax deferred e1031xchange, which will not delay the closing or cause any additional expenses to the Buyer. The Seller’s rights under this agreement may be assigned to e1031xchange, a Qualified Intermediary, for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and e1031xchange to complete the exchange.”

Use the same clause in the purchaser contract, when acquiring a replacement property, just substitute Buyer for Seller, and vice versa.

Step 4: e1031xchange signs HUD1 at settlement of the relinquished property

This can be done by facsimile or PDF.

Step 5: Deed is direct from exchange to buyer

e1031xchange does not go into the chain of title

Step 6: 45 days after settlement

Exchanger must notify e1031xchange in writing of potential replacement properties.

Step 7: 180 days to purchase one or more of the replacement properties.

But deadline is sooner if tax filing is done before the 180 day expiration. For example, if you sell your relinquished property on December 15, 2011, and submit your tax filing for 2011 on April 1, 2012, then the acquisition of the replacement property must happen on or before April 1, 2012, and not the typical 180 days after sale. To avoid this trap, have your tax preparer file a timely extension.

At closing of replacement property, assigns the rights in the contract to e1031xchange and e1031xchange then signs HUD as purchaser. Deed is direct to exchanger, e1031xchange never goes into the chain of title.

Step 8: Any remainder is returned but may be taxable as boot.

Step 9: Requirements for deferring the entire taxable gain.

Value of replacement property must be equal to or greater than the value of the relinquished.
Equity in replacement property must be equal to or greater than equity in the relinquished.
Debt on replacement property must be equal to or greater than debt on relinquished.
All of the net proceeds must be used to acquire the replacement property.
No net boot can be received.