Thursday, February 9, 2017

How does a 1031 Exchange Work


You have heard 1031, but not sure what it is and how it works..  Below we explain the process and benefit to property owners.







As the name implies, a 1031 Exchange contemplates an “exchange” of like-kind property instead of a traditional sale. If the transaction qualifies, any realized gain is deferred until the replacement property is sold later. The Internal Revenue Service Code sets forth the requirements that must be met for a transaction to benefit from 1031 Exchange treatment. In addition to the requirements found in the IRS Code, Qualified Intermediaries must follow additional rules legislated by the State of California for exchanges where the old or relinquished property or the property parked with the Exchange Accommodator Titleholder is located in California. 


1031 Exchange Rules 


In order to be considered for a 1031 Exchange, the properties exchanged must be held for productive use in a trade or business, or for investment. In addition, the requirements call for the seller to locate and designate a “like-kind” replacement property within 45 days of the original sale. The final purchase of the replacement property must be completed within 180 days of the original sale. A reverse 1031 Exchange is also possible that essentially contemplates the same process and timetable in reverse. The entire transaction must be handled by a Qualified Intermediary. The Qualified Intermediary must facilitate the transaction by taking possession of the titles and funds and distributing them to the appropriate party at the appropriate time. 


California 1031 Exchange Rules 


The State of California has legislated additional rules regarding Qualified Intermediaries. The 1031 Exchange Rules in California state in general, that anyone who facilitates an exchange for a fee, maintains an office in the state for the purpose of facilitating exchanges, or advertises services as a facilitator in the state, is required to follow the California specific rules.


  • Maintain a bond in the amount of $1 million, deposit an amount of cash or securities or irrevocable letters of credit in an amount not less than $1 million, or deposit all exchange funds in a qualified escrow account or trust account. Anyone who has sustained damages as a result of a facilitator’s violation of the California rules may make a claim against the bond, account or trust.
  • A Qualified Intermediary operating in California must maintain an errors and omissions policy of not less than $250,000 or must deposit cash, securities, or letters of credit in an account designated for the same purpose. Finally, a Qualified Intermediary in California must act as a custodian for all exchange funds and must invest those funds pursuant to a prudent investor standard.
A Qualified Intermediary, in most cases, is to withhold an amount equal to three and one-third percent of the sales price of any California property as contingency should the exchange not be completed.


Clawback Provision 


California has a “clawback” requirement for California property sold in a 1031 exchange and replaced with an out of state replacement property per California FTB Publication 1100 Irev 2007, section F. Non-residents are required to file a nonresident income tax return in the year the replacement property is sold in a taxable disposition.

Need help finding a 1031 Intermediary in South Orange County, don't hesitate to give our group a call.

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