Most buyers and sellers of real estate look at 1031 exchanges as an option as they consider their investment agenda. They figure that they defer paying state and federal capital gains taxes and depreciation recapture until they die and their estate goes to their spouse, charity, their children or grandchildren. They may also be able to stave off the alternative minimum tax that might sneak up on them if they were to sell a property.

But how do 1031's really work?

George Columbus was an Ohio investor. George learned from his broker that he would have to pay capital gains taxes when he sold his 10,000 sq foot warehouse. George wanted to defer his taxes and found out that if he bought more real estate and followed the Internal Revenue Service's 1031 rules he could do so successfully.

But his broker warned him, there are rules … many rules. Failure to comply with any of them could jeopardize your 1031. The Broker sent George to a real estate attorney and a CPA with experience in real estate transactions.

The Accommodator (or qualified intermediary)

Both of these professionals told George he would need to use an accommodator. In 1991, the IRS issued definitive guidelines that clarified 1031 exchanges and the role played by facilitators, accommodators or as they are technically known qualified intermediaries. These companies are unrelated to the seller, and in that way participate in the tax-deferred, like-kind exchange to facilitate the transaction so that it complies with the 1031 regulations.

In the sale transaction (also called a "Forward Exchange") the accommodator takes control of the funds from the sale and then releases the funds to the next deal, so that George does not take constructive receipt of the funds. Specifically, in order to create an "arm's length" transaction, the agreement between the George and Accommodator allows George to deed the property he is selling property to the Accommodator who then conveys the property to the Buyer. The Accommodator then holds the proceeds from that sale in an interest bearing account in favor of the George until an upleg property is purchased. Once again, in accordance with the agreement, the Accommodator then acquires the upleg property and conveys it to the George.

It is critical to have an accommodator in place before you close on the sale of your property to preserve your 1031 exchange.

Identification of new property

In order for George to have a proper 1031 exchange not only did he have to buy a like in kind property, he also needs to identify the next property he intendeds to purchase within 45 calendar days after he closed on the sale of his warehouse. The 45 day rule timing can also be tricky at the end of the year with all of the holidays like Thanksgiving, Christmas and New Year's. Here are the three IRS mandated rules:

1. Three property rule: George can identify three properties of any value or

2. 200% rule: George may identify more than three properties if the total fair market value of what is identified does not exceed 200% of the sale price of the relinquished property or;

3. 95% Rule: If George exceeds the 3 property rule and the 200% rule the exchange will not fail if he purchases 95% of the aggregate fair market value of all identified property.

Realistically, the key to property identification will tie into the realities of what properties are available in the marketplace that he can purchase given current financing considerations. Most investors chose the three property rule so they can go through the due diligence on three properties to find the one that works for them and that can actually close.

Identification must be delivered no later than the 45th day:

1. In writing

2. Delivered to a party to the exchange (escrow or accommodator)

3. Must be unambiguous and signed by George

4. It would be best to submit a couple of days early if a winter storm or a summer hurricane is looming on the horizon.

Debt

George must reinvest all of his debt on his existing property. He owed $150,000 in a mortgage on the warehouse that he sold. When he sells he will pay off that mortgage. When he buys the next property he needs to buy a property that will enable him to carry his debt position forward. He can borrow more money if he wants. Failure to replace the $150,000 debt is deemed "debt relief" to him and this becomes "mortgage boot" treated much like "cash boot" in other words he will be taxed on it.

Closing the deal

The exchange period is 180 days or the date George must file his tax returns, for the year of the transfer of the relinquished property (including extensions), whichever occurs first. Remember, if George relinquished property after October 18th, he actually has less than 180 days in which to complete his exchange unless he files for an extension.

Important facts

• George cannot set up an exchange after a deal has been closed.

• An exchange cannot be back dated.

• Funds in the accommodators account can be used to fund an earnest money or down-payment, as long as George does not touch any of the money.

• George cannot take cash out or receive cash in a 1031 Tax Exchange without creating a taxable event. If he elects to take some of the equity out of the sale proceeds in the way of cash or a note, this is called BOOT and is taxable (he will be subject to paying federal and state capital gains taxes on the amount of cash or boot received plus he will be paying 25% of the depreciation recapture).

Summary

We have reviewed many of the rules regarding 1031 exchanges in this article. It is critical to use an accommodator. There are many accommodators we recommend and we have listed three that we have closed with below. These are excellent companies with great reputations and knowledgeable leaders (often attorney's) at the helm. If you chose to complete a 1031 exchange you must use an accommodator. Take the time like George did to get a handle on the rules.

One final tip. If you need money out of an exchange, refinance at least one year and a day before your closing, otherwise the IRS will likely disallow your exchange.