Prior to 1979, most tax experts interpreted the 1031 exchange rules to mean simultaneous exchange of properties between two investors. In the “Starker” case, a federal court ruled against the IRS and made 1031 tax exchanges a practical means for real estate investors to avoid capital gains taxes.
After the Starker decision, investors no longer had to exchange properties, or even sell a property and purchase another on the same day. They could use the “delayed,” or Starker exchange. The flexibility of selling one property to person A, buying another property from person B up to 180 days later, and having the two transactions qualify as a single, tax deferred exchange made the 1031 exchange a reality for almost every investor.
The Delayed Exchange Process
Most 1031 exchanges involve at least three parties: the investor (exchanger) who is doing the exchange; the buyer who is purchasing the exchanger’s old (relinquished) property; and the seller who is selling a new (replacement) property to the exchanger.
The delayed exchange features a fourth party, the qualified intermediary. The qualified intermediary acts as a proxy with whom the exchanger executes the exchange. The exchanger obtains the “Safe Harbor” protections of the tax code because exchange proceeds pass through the qualified intermediary. The diagram below illustrates the steps for completing a delayed exchange.
- An investor (the exchanger) signs a contract to sell an investment property to a buyer. The sold property is subsequently called the relinquished property.
- The exchanger assigns his/her rights in the sales contract to the qualified intermediary (Q.I.).
- At the closing of the relinquished property, the deed passes from the exchanger to the buyer as in any normal sale, but the purchase money passes from the buyer to the Q.I.
- The exchanger has a maximum of 180 days from the closing on the relinquished property to acquire a replacement property.
- The exchanger identifies possible replacement properties in writing to the Q.I within 45 days from the closing on the relinquished property.
- The exchanger signs a contract with a seller to purchase a replacement property, but assigns his/her rights in the purchase contract to the Q.I.
- At the closing of the replacement property, the seller gets his payment from the Q.I., but transfers the deed directly to the exchanger as in a normal purchase.