Due to its nature as a form of legal transaction, the 1031 exchange is subject to a wide variety of rules and stipulations. In order for the exchange to be legal and effective, it is critical that you adhere to all the rules and regulations completely.
The first important factor of any 1031 exchange is that the property being sold (or, in 1031 parlance, "relinquished") must not be your primary residence. The only properties that are eligible for the 1031 exchange are those that are held for another reason – generally an investment or business interest. There are very different rules and regulations surrounding the sale and tax status of a property that is someone's main residence and one that is not, and the 1031 exchange program is simply not applicable to a property that is a primary residence.
The second major factor of any 1031 exchange is that the property you are selling (again, the "relinquished" property) must be "of like kind" as the property you intend to buy (the "replacement" property). The rationale behind this regulation is to protect the spirit of the 1031 program, which is to assist real estate investors in growing the value of their assets. This means that the property you are selling must be replaced with something that is similar in terms of use: farmland, for example, must be replaced with farmland, and a three-flat that you rent out should be replaced with another building you intend to rent to tenants. Fortunately for exchangers, this "like kind" rule allows for broad interpretation of the categories into which various properties fall – and two properties of like kind do not have to be of the same level of quality. A swath of low-producing farmland, for example, can be "exchanged" with land that is of much higher quality.
The third major factor in a legal 1031 exchange is the requirement that a qualified intermediary be used to handle the exchange of funds. When the exchanger (read: you) sells the relinquished property, the proceeds of the sale go not to the exchanger's pocketbook but rather into the hands of the qualified intermediary. The qualified intermediary then holds onto the funds while the exchanger seeks a replacement property and moves to finalize that purchase. When the exchanger legally purchases a replacement property, the transfer of funds is thus from the hands of the qualified intermediary (rather than the exchanger him or herself). The use of a qualified intermediary in all 1031 exchanges guarantees that the tax-sheltered money will not be ill-used between transactions – and helps to ensure that all 1031 exchanges will be overseen by skilled and knowledgeable professionals. |
