4TH REQUIREMENT: USE OF A QUALIFIED INTERMEDIARY
Sellers cannot touch the money in between the sale of their old property and the purchase of their new property. By law the taxpayer
must use an independent third party commonly known as an exchange partner and/or intermediary to handle the change. The party who
serves in this role cannot be someone with whom the taxpayer has had a family relationship or alternatively a business relationship
during the preceding two years. The function of the exchange partner/intermediary is to prepare the documents required by the IRS at the
time of the sale of the old property and at the time of the purchase of the new property. The intermediary must hold the proceeds of the
sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds and
must treat the interest as ordinary income during the period of escrow.
If 1031 documents are prepared incorrectly, the IRS will disallow the exchange. No state or the federal government, regulates qualified
intermediaries. The majority of companies performing this function are not bonded as there are no licensing requirements. Through the
Florida BAR client relief fund, each attorney in the state of Florida is, in reality, bonded up to $1,000,000.00 per transaction.
Example #1: Joseph copies 1031 forms he received and sets up a special account at his bank for the sale proceeds to go into following
closing. He never touches the funds and had his bank wire all of the proceeds to the title company for his new purchase property. Will this
suffice?
No. By failing to have a qualified intermediary, Joseph exercised dominion and control over the funds and therefore the exchange will be
disqualified.
5TH REQUIREMENT: TITLE MUST BE MIRROR IMAGE
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you and your wife
are married and sell the old property than you and your wife must also be on the title to the new property. If a trust or corporation is in title
to the old property that same trust or corporation must be on title to the new property.
If only the husband is on the old property, but his wife is required to be on title to the new property to help qualify for the loan, one
solution to avoid this problem prior to the sale would be for the husband to Quit Claim his interest to himself and his wife. Similarly, if
shareholders of a corporation or partners in a partnership or members of a LLC are desirous of selling their respective corporate interest,
this is prohibited. What qualifies for 1031 treatment is real estate and not partnership interests. To accomplish this objective the entity
must be liquidated and deeds must be issued to provide the respective partners with a tenants in common interest in lieu of a partnership
or related interest.
Example #1: Alex owns a warehouse building in his own name but wants to buy a condominium in the name of a new limited liability
company he wants to set up. Can he do this?
No. The new property must be acquired in his own name to successfully complete the exchange.
Example #2: Barney is married to Betty and owned a condominium prior to his marriage that is titled in his sole name. Can he take title
to the new lot purchase in both his name and Betty’s name?
No. Barney must first complete his exchange in his own name. Afterwards he may Quit Claim his interest to himself and Betty as
husband and wife after the exchange is complete.
6TH REQUIREMENT: REINVEST EQUAL OR GREATER AMOUNT
In order to defer 100% of the tax on the gain of the sale of old property, the new property must be of equal or greater value. There are
actually two requirements within this rule. First, the new property has to be of greater or equal value of the one which is sold. Secondly,
all of the cash profits must be reinvested. In reality you may deduct closing expenses and commissions from the sale of the property
being sold. If the property is being sold for $500,000.00 and the actual net amount after closing expenses is $465,000.00 all that is
required to be spent for the replacement property is a total of $465,000.00. Closing expenses associated with the purchase may be
added into the purchase, as well as capital improvements completed within 180 days together with furnishings. In fact, a taxpayer may
make an unlimited number of capital improvements as well as spend up to 15% of the acquisition cost on personal property.
A party who elects to do an exchange and take cash out may do so, however, any cash received will be taxed at the corresponding rate
of ordinary income if held for less than one year or 15% if held for more than one year.
Example #1: Steve owns a property he paid $250,000.00 for and is now selling for $400,000.00. He has a $150,000.00 mortgage
against the property and wants to buy a smaller condo for $250,000.00 with the cash. Does this qualify for tax deferral treatment?
No. Steve is buying down from $400,000.00 to $250,000.00. Accordingly, tax is owed on the amount of the buy down, which is
$150,000.00.
Example #2: Steve decides to buy a replacement property for $500,000.00 and obtains a $400,000.00 loan using $100,000.00 of the
$150,000.00 cash that the qualified intermediary is holding. Is his exchange fully deferred?
No. Despite buying up, Steve did not use all of the cash and will be taxed on $50,000.00.
7TH REQUIREMENT: REVERSE EXCHANGES – TITLE TO BOTH
PROPERTIES CANNOT BE IN SAME NAME AT SAME TIME