Qualified Intermediary Requirements: 1031 Exchange Series Part Five

If you’ve been following along with our seven-part series on 1031 Exchange basics, you know that we’ve already covered the first three of the six basic requirements. Now, we are moving on to the fourth requirement, using a Qualified Intermediary. The IRS requires the process of a 1031 Exchange to be documented and managed by the Qualified Intermediary. In this article we will discuss the requirements for a Qualified Intermediary (QI). Both their role in the exchange process and what to look for your QI.

1031 Exchanges Require a Qualified Intermediary

The IRS has a strict set of rules and time limits that you must stick to in order to qualify for a 1031 Exchange. Using a Qualified Intermediary to document all the transactions of your exchange and hold your proceeds is part of those rules. The IRS code states that an unrelated third party must document and manage just the 1031 Exchange part of the transaction. During the exchange process, you will use the services of your usual and familiar real estate professionals. This may include a real estate attorney, a title company, an accountant for tax reporting, and probably several real estate agents. A Qualified Intermediary is simply another professional that is added during a 1031 Exchange. In addition to their mandated role, a good QI will also act as your guide through the process.

Something important to note here is that the Qualified Intermediary MUST be involved before the closing of the sale of your investment property. A 1031 Exchange starts with the sale of a piece of investment real estate and ends with the purchase of replacement property. But this only works if your Qualified Intermediary is in place prior to the sale.

 

Who Can Be Your Qualified Intermediary?

The Qualified Intermediary is an unrelated third party. While we have mentioned a “third party” before, it’s important to emphasize that the Qualified Intermediary must truly be a third party. It cannot be your attorney, real estate agent, husband, or wife, etc. It has to be a completely unrelated party where all they do for you is document and manage your 1031 Exchange.

While the statue isn’t completely clear on what “qualified” is, it is crystal clear on what disqualifies someone from this role. That is: if there’s an agency relationship, a business relationship or a family relationship, the person or entity would be disqualified. This essentially means that as long as you haven’t purchased used tires from the used tire shop down the road, they could technically act as the Qualified Intermediary. However, that’s clearly not in your best interest. To understand why, let’s take a look at exactly what the Qualified Intermediary does.

What does the Qualified Intermediary Do?

The Qualified Intermediary will work alongside you and the rest of your regular professionals to document the entire 1031 Exchange and hold the proceeds from your sale. At a minimum, this includes:

  • Creating an exchange agreement (between QI and the investor)
  • Providing the assignment of contract rights (signed by the investor and enacted by the title company)
  • Giving notification (all parties to the transaction have to be notified – no standard of when)
  • Receiving and maintaining sale proceeds during the transition into the new investment/until the end of the exchange

Let’s take a closer look at these official aspects of the QI’s role.

EXCHANGE AGREEMENT

There will need to be an exchange agreement between you and your Qualified Intermediary that lays out all of the requirements we discuss in this article series. This agreement will specify what your role is going to be, what you’re going to have to do to finish the exchange, and what the Qualified Intermediary is going to do for you. This exchange agreement will be your contract with them.

ASSIGNMENT OF RIGHTS

As part of the process of using the Qualified Intermediary, there must be an assignment of rights. This is where you assign your rights to the sell the property to your Qualified Intermediary. Many states and jurisdictions already have real estate contracts that have check the boxes or default cooperation addendums for a 1031 Exchange. If that is not the case with your contract, we recommend you simply make your contracts assignable if possible. Regardless, this assignability and the exchange documents prepared by your QI allow the title company to direct deed the properties from the exchanger to the buyer and from the seller to the exchanger.

Note that your QI should never take title to either the relinquished or replacement properties. The QI is the assignee only on the settlement statement. This is an aspect of the assignment of rights that should be discussed in your Qualified Intermediary selection process (see more below).

NOTIFICATION

The statute does not specify how or when the parties to the exchange must be notified, only that it is required. Some exchangers have experienced more aggressive bargaining situations when the seller realizes a 1031 Exchange is in process. As a result, most QIs opt to provide this required notice as part of the closing process.

RECEIPT AND MAINTENANCE OF PROCEEDS

For an exchange to be valid, the investor may not have actual or constructive receipt of the proceeds from the sale of their relinquished property. Remember how we said before that you must have the Qualified Intermediary before you close the sale of your investment property? Part of the reason why is that after the closing of the sale, your proceeds must go into an exchange account with the Qualified Intermediary. The IRS considers funds in escrow with the title company constructive receipt by the seller, so the funds must be transferred to the QI. Then, when you purchase your replacement property, the funds will be transferred by the QI directly to the title company for closing.

Finding and Hiring the Right Qualified Intermediary

As your QI has to be an unrelated third party and will be holding significant cash on your behalf, we recommend you look for someone that meets these five criteria:

  1. Uses dual signatory segregated, qualified escrow accounts for your exchange funds (at no charge).
  2. Guarantees their exchange documentation.
  3. Provides support and documentation in the case of an IRS audit (at no charge).
  4. Is easily accessible to answer questions (at no charge).
  5. Has extensive, verifiable experience and a solid reputation.

While the exchange fee charged is a consideration, there is a range and a variety of potential additional charges among QIs who meet the above criteria. We recommend you check out our previous article on how much an exchange should cost to see what you should be paying and what your fee covers.

Don’t miss the next part of our series on the 1031 Exchange basics, when we’ll be talking about all of the necessary title requirements.

 

Originally posted on The Bigger Pockets Member Blog.

180-Day Rule: 1031 Exchange Series Part Four

So far in our seven-part series on 1031 exchange basics, we have discussed the six basic requirementsproperty being held for investment, and the 45-day identification rule. In the fourth part of our series, we are going to discuss more in depth the third requirement for a 1031 exchange which is the 180-day rule. If you’re curious about what this rule is and the timing requirements behind it, continue reading on to learn more.

The 180-Day Rule

As we have discussed in previous articles, there are two critical timing requirements when completing a 1031 exchange. This first is the 45-day identification rule which we discussed in part three of this series. The second is the topic we are discussing now, the 180-day rule. The 180-day exchange period runs concurrently with the 45-day identification rule. Therefore, if you haven’t read that part yet, we highly recommend it. However, here is a brief summary:

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Day one of the 45-day identification period starts on the day of your closing. You have 45 calendar days from the day of your closing to identify the replacement properties and take title to it OR produce a written list of the replacement properties that you’re going to use.

Similarly, the 180-day rule also starts on the day that you close your property. As we also mentioned, it runs concurrently with the 45-day identification rule. What this means is you have a total of 180 days to complete the entire 1031 Exchange transaction. While you may have 45 days to identify properties, you have a total of 180 days to close on the new property and accept the title to it. It’s important to note that the property you choose must be one of the properties from your 45-day list.

You Must Choose a Property from Your 45-Day List

One of the requirements of the 180-day rule is that you must choose a property from the45-day list you have turned in. This is a Federal IRS rule and there are no exceptions and no extensions. 180 days to complete an exchange sounds like a long time. It is the 45-day period is where most people get lost or fall behind. It is imperative you start looking for replacement properties as soon as possible and make a list of potential properties. In the end, when the 45 days are up, you are left to choose from that list and that list only. You will then have to close on one of those properties within the 180-day window.

You May Have Less than 180 Days

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If you’ve ever read over any federal laws, you know that they are very complicated and nuanced. Unfortunately, there is no exception here. With the 180-day rule, you actually have the lesser of 180-days or to the date of your next tax filing. The reason for this is the IRS wants your 1031 Exchange wrapped up and completed before you file your taxes. Therefore, it has to be reported on your next tax return.

For example, as everyone knows Tax Day is April 15th. If you sold your relinquished property on December 15th, you would have until April 15th to completely wrap and finish your 1031 Exchange by purchasing your replacement property or properties. This could be significantly less time than the allowable 180 days. You can easily avoid this by filing for an extension on your taxes. But, it’s a very important aspect to keep in mind. If you know you aren’t going to be able to complete your 1031 Exchange before taxes are due, go ahead and file for an extension.

Timing is Everything with the 180-Day Rule

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In the last two articles, we’ve discussed a lot about timing. The reason for this is because timing is everything in a 1031 Exchange. Properties must be identified within 45 days and you then have 180 days to close on one or more of those properties, and only those properties. However, keep in mind that you may actually have less than 180 days if you are due to file your taxes before then. If that is the case, you may want to request an extension on your taxes so you have time to finish your 1031 Exchange.

This article was originally posted at https://www.biggerpockets.com/member-blogs/12255/91039-180-day-rule-1031-exchange-series-part-four.

45-Day Identification Rule: 1031 Exchange Series Part Three

If you’ve been following along with our seven-part series on 1031 exchange basics, you’ve already learned about the six basic requirements. We’ve already discussed the requirement of the property being held for investment in part two. Now, in part three, we will discuss the second requirement of a 1031 exchange which is the 45-day identification rule. Continue reading on to understand what the rule is and why it’s important.

The 45-Day Identification Rule

There are two very critical timing requirements when completing a 1031 exchange. This first is the 45-day identification rule and the second is the 180-day rule, which we will discuss in part four of this series. The 45-day identification rule is relatively straightforward. This states that you have 45 days from the date of closing your sale in order to identify your potential replacement properties. Before you begin to panic, this doesn’t mean closing on them or getting them under contract. It simply calls for you to identify them.

While 45 days seems like a lot of time before you sell, once people close, they tend to go into panic mode. Don’t let this happen to you! Our best recommendation is to start the search for your replacement property well before you close your sale. It’s important to note that day one starts on the date of your closing. You then have to the end of 45 calendar days to do one of two things:

  • Identify the replacement properties and take title to it OR
  • Produce a written list of the replacement properties that you’re going to use

If you decide to go with the second of the two options, you must actually write the list and it needs to be a specific identification. For example, you can’t just write down, “I want to buy a unit in the Carrollwood condos”. Rather, you’ll need to be more specific by saying, “I want to buy (or I’m thinking of buying) 4352 Unit C in the Carrollwood condominiums”.

Narrowing Down the List

The list of potential properties you need to create within 45 days is very important. Therefore, it’s critical that you get on top of it right away. Only the property that is on that list will qualify to finish your 1031 exchange. Now, your first thought might be to just load up your list with twenty or thirty properties. It makes sense but the IRS has anticipated this and placed limits upon it. The IRS creates a sort of three-part funnel where they try to make you be very specific and limit the number of properties that you identify for your exchange. This part can get a little tricky, so we’re going to break it down further.

First Part of the 45-Day Identification Rule

The first part of the 45-day identification rule states that as long as you name three or fewer properties in your list, it doesn’t matter how much they’re worth. For instance, if you sell a small condo for $100,000, you could name three $5 million-dollar offices on your list and it would be fine. Of course, you might have a little trouble closing on those if all you’re selling is a $100,000 condo. However, you are still able to do it.

Second Part of the 45-Day Identification Rule

Now, the second part of the 45-day identification rule covers what happens when you list more than three properties. In this situation, the total value of that list can be no more than 200% of the value of what you sold. If we go back to our last example with the $100,000 condo, you would be able to list four replacement properties worth $50,000 each. That’s because $50,000 x 4 = $200,000 which is 200% of the original sale of $100,000. You cannot go over this limit. If you tried to list three of those $50,000 properties and then a $75,000 one, you would be over the limit and it would disqualify your entire exchange.

In order to make this just a bit more confusing, there is one more exception to listing more than three properties. If those four or more properties have to be more than 200% of the value of what you sold, you can still do it; but only if you actually closed on 95% of the value of your list. This is the trickiest part of IRS law and can be perplexing to try and understand, even for professionals.

If we go back to our example of selling a condo for $100,000 and listing four replacement properties. Consider if on this list there are three $50,000 lots and one $75,000 lot. So, more than three are named and the total of the four is more than 200% of what you sold. HOWEVER, if you closed on all four of those lots, then you would have closed on 95% of the value of the list. Therefore, you are able to do that.

There are No Extensions and No Exceptions

It’s in your best interest to keep this process simple and quick. 45 days can go by very quickly and the IRS does not offer any individual extensions or exceptions. Once the 45 days have passed, whatever is on that list are the only properties you can choose from. It doesn’t matter if you get outbid on one, another burns down, and the owner of the other one dies and it goes into probate, those are the properties the IRS says you can purchase. There are no individual extensions and no exceptions. This is where most 1031 exchanges usually fail, therefore it’s important to take it seriously.

We’ll offer one last example to make sure you completely understand the 45-day identification rule.

Billy and Jane have sold their rental property for $100,000. They want to identify two or three $1,000,000 replacements. Can they do that? The answer is yes because they only named three or fewer potential properties.

However, what if Bill and Jane sell that same property for $100,000 and they want to identify four little condos for $75,000 each. Can they do that? Well, the answer is maybe. Although it does break the 200% rule, as long as they closed on all four of those, they would have closed on 95% of the list. Therefore, that would qualify under the IRS 45-day requirements.

The best advice we can offer is to start looking for properties before you close. Don’t take too long to get started. We offer a convenient 1031 Exchange Timeline Calculator that will help you with the 45-day identification rule as well as the upcoming 180-day rule. We highly recommend you bookmark this page and use it whenever you’re planning your 1031 exchange.

Held for Investment: 1031 Exchange Series Part Two

In the first part of our seven-part series on 1031 exchange basics, we discussed the six basic requirements. The first of those six requirements state that the real estate must be held for investment. In this, the second part of our series, we will discuss what held for investment means, what property qualifies, and how the holding period can be determined.

Held for Investment

This requirement states that in order to qualify for a 1031 exchange, the real estate must be held for investment. It’s vital to remember that this is different from section 121, which refers to your primary residence. With a 1031 exchange, we’re discussing investment real estate. That means we’re not concerned with the type of property as much as the use of it. Overall, the use of the real estate is what’s most important.

There are three different types of uses that qualify under the held for investment rule. This includes uses for trade, business, or investment. You can read more about each of them below.

  • Trade
    This means that you are holding the real estate for productive use in trade. For example, this could be a factory where you store or produce clothing if you’re a retail designer. If you work as a plumber, this could be a building where you keep items that you need for your trade such as toilets or pipes.
  • Business
  • Holding real estate for business purposes covers properties that you generate income off of. This may be an apartment complex that you rent out to tenants. It could also be a shopping center where you lease out space to businesses.
  • Investment
    The final use that qualifies under the held for investment requirement is holding the property for investment purposes. This means you’re trying to garner the incremental increase in value as it relates to a factor over time. To put it simply, you bought the real estate to hold it while it appreciates or increases in value over time.

Investment versus Inventory

Most of us don’t think of real estate as inventory. But, this is an important concept to understand when dealing with IRS rules and regulations regarding 1031 exchanges.

While we spoke about investment property above, it’s important to note the mention of appreciation as an increase in value over time. This is a critical factor in separating investment from inventory.

You cannot purchase a property for $50,000, fix it up, and promptly sell it for $100,000 and defer the tax with a 1031 exchange. In this case, the IRS considers such flipped property as inventory. Since you purchased it with the intent to simply turn around and resell it at a profit, it does not qualify for a 1031 exchange.

However, if you purchased the property at $100,000, fair market value, and a few years later it’s worth $200,000, that is appreciation. By holding the property and allowing it to appreciate in value, it is considered investment real estate.

The first scenario does not qualify for a 1031 exchange but the second one does.

Property That Does Qualify

A 1031 exchange covers U.S. property for U.S. property with a few exceptions. These exceptions include the U.S. territories of Guam, American Samoa, and the U.S. Virgin Islands. For example, you could sell a property in the U.S. and buy a property in St. Thomas (in the U.S. Virgin Islands) and do a 1031 exchange. Even though Puerto Rico is a U.S. territory, you are unable to do an exchange between a U.S. property and one in Puerto Rico due to the way their commonwealth is setup. You are able to sell foreign real estate and buy foreign real estate using a 1031 exchange. However, if it is a U.S. property, only other U.S. properties or ones from Guam, American Samoa, and the U.S. Virgin Islands will qualify.

As a general rule of thumb, rental properties will always qualify since you are holding them to generate income. Raw land is also always an investment. This is because you’re investing in raw land, not because you expect to turn it for a quick profit. If it does happen to appreciate quickly, it’s up to you and your accountant to decide what the intent was when you bought it.

Examples of Held for Investment Exchanges

To understand this a little better, let’s look at an example. Let’s say you purchased a piece of raw land at an auction. Then, three months later, you are able to sell that land for three times the amount you bought it for. Would this qualify for a 1031 Exchange?

That depends. When you bought the land, did you know it was going to be worth that much more immediately? Did you buy the land primarily to resell it? If you answer yes to those questions, you would be flipping the land and therefore not eligible for a 1031 exchange.

But what if, as one of my clients experienced, you never put the land up for sale? What if you had already planted crops? Then, what if someone approached you and offered to buy the land? In this situation, my client clearly intended to hold the land for productive use. But then the local gas company identified his land as the perfect place for a distribution hub and made him an offer he couldn’t refuse. In this instance, he clearly intended to hold it for productive use so even though his intent changed and he sold it quickly, it still qualified for a 1031 exchange.

Another example would be if you owned a duplex that you bought a while back. Let’s say you now want to sell and go buy a vacation condo on the beach. You’re going to use the beach condo a little bit but you also want to rent it out. Can you do a 1031 exchange in this situation? Absolutely! This still qualifies as rental property that you intend to hold. Personal use does not disqualify it, although there are some IRS rules and regulations about that, too (https://www.biggerpockets.com/blog/vacation-home-1031-exchange).

Intent is Key for the Hold Period

Typically, the hold period that most investors use for 1031 exchanges is longer than twelve months. Now, there’s no magic to that, because there is no statutory holding period. In the past, if you held property for more than twelve months, you would automatically qualify that property as a capital gain “long term”. If this property was sold with less than a year’s ownership, you would pay ordinary income. However, that easier measure is no longer valid and it is very difficult to put a time period down now.

My best advice is that longer is better rather than shorter. This is because the keyword to the entire statue revolves around the single word of “intent”. You are going to sell property that it has been your intent to hold for productive use in trade, business, or investment. However, now you’re going to purchase a new property that you intend to hold for productive use in trade, business, or investment. That’s the basics of a 1031 Exchange.

In summary, there are two ways to demonstrate your intent to hold for investment as there is no statutory holding period. The first way is that longer is always better than shorter. The second way revolves around your past history. What have you’ve always done? Do you have a history of buying property and holding onto it and renting it? Then you’ve set up something to demonstrate what your intent is. And your established intent is key when satisfying the requirement that the property being exchanged for investment.

This article originally posted at: https://www.biggerpockets.com/member-blogs/12255/90843-held-for-investment-1031-exchange-series-part-two.

The Six Basic Requirements of a 1031 Exchange

When you’re looking to keep your taxes working for your own benefit with a 1031 exchange, it’s important to understand the requirements that need to be met. There are six basic requirements of a 1031 exchange. All six of these must be met in order for a 1031 exchange to be successful. In the first part of our seven-part blog series on 1031 exchange basics, I’ll go over the six basic requirements.

The Six Basic Requirements of a 1031 Exchange

  1. Held for Investment
  2. 45 Day Identification Rule
  3. 180 Day Rule
  4. Qualified Intermediary Requirements
  5. Title Requirements
  6. Reinvestment of Cash / Equal or Up Rule

I can’t stress enough that all six requirements need to be met. Even if you meet five of the six, the 1031 exchange will still fail. This type of exchange is authorized in the tax code and overseen by the internal revenue service (IRS). While they do have to allow exchanges and follow their code, they don’t have to make it easy. That’s why it’s important to make sure you understand and have a plan in place to meet all six basic requirements of a 1031 exchange before you proceed.

Within the six requirements, you’ll find that there is a requirement for the type of real estate. You’ll also have to follow certain timing rules such as the 45-day rule and the 180-day rule. There is a requirement for the use of a qualified intermediary to assist in the exchange. There are also special requirements surrounding the title as well which include how the title must be held. Finally, you’ll have to make sure you meet the reinvestment requirements. This specifically deals with what you have to put back in, or reinvest, to make sure that you will get the full amount of tax deferral.

In this seven-part blog series on 1031 exchange basics, I’ll cover all of the six requirements. This includes what they are, how they work, and what you need to do in order to achieve a successful 1031 exchange.You can also find this information via the Video Training link at www.the1031investor.com.

This article first appeared on my Bigger Pockets member blog.

There are more ways to control your money than just receiving cash. Even funds held in escrow by your title company are considered yours and can constitute constructive receipt.

Constructive Receipt and 1031 Exchanges

Protect Your 1031 Exchange – File for an Extension

If your 1031 exchange began in late 2019, you may need to file for an extension of your tax deadline. This is because the normal exchange period of 180 days will be shortened to your tax filing day (April 15th with out an extension) if your surrendered property closed between October 19th and December 31st, 2019. Therefore, it is important to remember to file for an extension in order to protect your complete 180-day 1031 exchange period.

Why does this happen? The regulations outlined in Section 1031 state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”

To explain this a little better, your normal 180-day exchange period can be reduced if you began your 1031 exchange after October 19th, 2019. If you are unable to purchase a like-kind replacement property before the deadline of April 15th, you should consider filing a tax extension in order to allow yourself the full 180 days.

How this Works

For example, Mr. Jones sells Vista Apartment Complex as part of a 1031 Exchange on November 26, 2019. Although the 180th day after this sale of his relinquished property is May 24, 2020 – his tax filing deadline occurs before this and automatically becomes his 1031 Exchange deadline as well. By filing an extension to his tax return, Mr. Jones can extend both his tax filing deadline and revert his 1031 Exchange deadline to the full 180-day exchange period.

Therefore, if your relinquished property closed between October 19th and December 31st, 2019, it’s important to file for an extension on or by April 15th, 2020. This will ensure you don’t lose out on your full 180-day 1031 exchange period.

Resources

To determine if the exchange you initiated in 2019 has a 180 day deadline after April 15th, use my 1031 exchange deadline calculator at The 1031 Investor.

To get more information about how to file for an extension, check out the IRS website for complete instructions.