A 1031 exchange is a tax-deferred exchange which allows an owner of business or investment property to exchange that property for new property without incurring income tax on the gain.
The 1031 Exchange Process
Prior to closing on the sale of the sold property:
Step 1: Consult with your tax advisor for a 1031 tax exchange
Step 2: The Agreement
Contact an 1031 exchange intermediary to reserve an account number to use on all the exchange documents. The owner of the property (“the Owner”) should complete both an Exchange Agreement and a Qualified Exchange Trust Agreement.
Step 3: Assigning the Sold Property Contract
The Owner assigns rights but not obligations under the Sale Contract to a Qualified Intermediary and provides notice of the assignment to the Buyer. At the closing, title for the sold property is transferred directly from the Owner to the Buyer (known as direct deeding). A copy of the completed Assignment of sold property Contract and a copy of the Sale Contract should be sent to your intermediary.
Step 4: Net Proceeds
Net proceeds from the sale must be payable to the Qualified Intermediary. Payment may be in the form of a check payable to them or a wire transfer. It is important that the Owner never have actual or constructive receipt of the funds from the sale. Once proceeds are received by them, they are invested for the benefit of the Owner.
Within 45 days following the sale and transfer of the sold property:
Step 5: Identifying Replacement Property
The Owner completes the Identification of Replacement Property form. Replacement property must be specifically and unambiguously identified. For real estate, this could be a valid street address or a legal description. Identification requirements for personal property may vary depending on the item, but make, model and year are usually sufficient. Delivery of the Notice to the intermediary may be by hand, fax, mail, or over-night courier and must be postmarked by or received by 11:59 p.m. on the 45th day. Prior to midnight on the 45th day, the Identification may be amended or revoked, but after the 45th day, no changes in the Identification will be accepted.
Within 180 days following the sale and transfer of the sold property:
Step 6: Assigning the Replacement Property Contract
The Owner assigns rights but not obligations under the Purchase Contract to the Qualified Intermediary and provides notice of the assignment to the Seller. A copy of the completed Assignment of Replacement Property Contract and a copy of the Purchase Contract should be sent to the intermediary.
Step 7: Disbursements
Owner sends a Direction to Disburse Funds from the Exchange Account. Funds are made payable to the Seller of the Replacement Property or to the Seller’s agent. At the closing, title to the replacement property is transferred directly from the Seller to the Owner (direct deeding).
You can always check out what the IRS says about 1031 Exchanges prior to entering into a 1031 Exchange.