Common 1031 Exchange Transactions Facilitated by STEC
Forward Exchange
A forward exchange is the most common type of 1031 exchange. In these exchanges, the disposition of the relinquished property occurs prior to the acquisition of the replacement property. The forward exchange provides exchangors up to 180 days to purchase a replacement property after the relinquished property is sold. The use of a qualified intermediary or other safe harbor is required to facilitate a valid forward exchange. In general, the steps required to execute a forward exchange that will be facilitated by STEC, serving as qualified intermediary, are as follows:
Step 1: Relinquished Property Purchase Contract: Entered into between you and the buyer of the relinquished property and should contain a "cooperation clause." Contact us for a model.
Step 2: Relinquished Property Exchange Documents: These documents are provided to you by STEC and must be signed and dated before or as of the date of the closing of the disposition of the relinquished property.
Step 3: Relinquished Property Closing and Exchange Fund: The closing of the disposition of the relinquished property consists of the conveyance of the relinquished property to the buyer directly from you but will represent a: (1) transfer from you to STEC of your rights under the relinquished property purchase agreement in exchange for the replacement property that you will acquire at a later date; and (2) sale of the relinquished property from STEC to the buyer for cash. The funds from the sale of the relinquished property are delivered directly to STEC so that you will, at no time, be in either actual or constructive receipt of the exchange funds. STEC will hold the exchange funds and provide you with replacement property identification forms for use within the 45-day identification period following the sale of the relinquished property.
Step 4: Relinquished Property Purchase Contract: Entered into between you and the seller of the replacement property and should contain a "cooperation clause." Contact us for a model.
Step 5: Relinquished Property Exchange Documents and Identification: Replacement property exchange documents are provided to you by STEC and must be signed and dated before or as of the date of the closing of the acquisition of the replacement property. The replacement property must be identified to STEC in writing within 45 calendar days of the disposition of the relinquished property.
Step 6: Relinquished Property Closing: STEC will deliver the exchange funds to the settlement agent to be used to acquire the replacement property. The closing consists of the conveyance of the replacement property from the seller directly to you but will represent a: (1) purchase of the replacement property from the seller by STEC; and (2) transfer of the replacement property to you directly from the seller in completion of the exchange. To qualify for tax-deferred treatment, this closing must occur by the earlier of 180 days from the (a) date of the closing of the disposition of the relinquished property; or (b) the due date of your federal income tax return for the year in which the relinquished property was sold, including extensions.
Step 7: Final Documents and Reporting: At the conclusion of the exchange, STEC will provide you with a copy of the fully executed exchange documents, including a statement reflecting the receipt and disbursement of all exchange funds to allow you and your tax advisor to complete state and federal income tax forms required to report the transaction as a 1031 exchange.
Reverse Exchange
STEC can assist you with the entire reverse 1031 exchange transaction by setting up a separate entity to serve as the EAT and we also can act as the qualified intermediary. With STEC’s breadth of experience and security, your reverse 1031 exchange will be facilitated efficiently and competently.
A reverse exchange occurs when an exchangor wants to (or must) acquire a replacement property prior to the closing of the relinquished property disposition. In this type of 1031 exchange, the exchangor does not actually acquire the replacement property first and dispose of the relinquished property later. Instead, the exchangor engages an EAT to take title to either the relinquished property or the replacement property. This allows the exchangor to comply technically with 1031 exchange requirements to dispose of the relinquished property prior to acquiring the replacement property. Reverse 1031 exchanges must be completed within 180 days and the 45-day rule relating to the identification of the replacement property also applies, with a slight tweak. In general, there are two types of reverse 1031 exchanges: an “exchange last” transaction and an “exchange first” transaction.”
Exchange Last Transaction (park title to replacement property): In an exchange last transaction, the exchangor must acquire the replacement property prior to disposing of the relinquished property. To facilitate the 1031 exchange, the EAT acquires title to the replacement property from the seller. The acquisition of the replacement property by the EAT is funded by the exchangor or by a third-party loan arranged by the exchangor. Within five days of the transfer of the replacement property to the EAT, the exchangor and the EAT must enter into a QEAA, which provides the terms and conditions of the exchange. The EAT leases the replacement property to the exchangor under a triple net lease, allowing the exchangor to receive the economic benefits and burdens of the replacement property during the time that it is held by the EAT.
The exchangor must identify within 45 days after the EAT’s acquisition of the replacement property, the relinquished property to be exchanged for the replacement property. The identified relinquished property must be sold, and the replacement property transferred to the exchangor to complete the exchange within 180 days of the acquisition of the replacement property by the EAT.
When a buyer for the relinquished property is found, the relinquished property is sold, with title transferring directly from the exchangor to the buyer. The funds from the sale of the relinquished property are transferred to the qualified intermediary to acquire the replacement property from the EAT. Upon receiving the funds, the EAT will pay off the loan from the exchangor and use any remaining exchange funds to pay down the third-party loan on the replacement property prior to transferring the replacement property to the exchangor. If the sale of the relinquished property generates more exchange funds than necessary for the qualified intermediary to acquire the replacement property, the exchangor may identify additional replacement property within 45 days of the transfer of the relinquished property, and complete the additional acquisition within 180 days of the relinquished property transfer. Otherwise, the excess exchange funds will be transferred to the exchangor as boot.
Exchange First Transaction (park title to relinquished property): In an exchange first transaction, the EAT acquires title to the relinquished property from the exchangor, generally subject to any existing third-party financing and with a purchase money loan from the exchangor. The exchangor simultaneously takes title to the replacement property from the seller. Both of these transactions flow through the qualified intermediary with the use of direct deeding. Within five days of the transfer of the relinquished property to the EAT, the exchangor and the EAT must enter into a QEAA, which provides the terms and conditions of the exchange.
When a buyer for the relinquished property is found, the relinquished property is sold, with the funds generated by the sale used to retire existing third-party debt on the relinquished property and to repay the exchangor for the original loan. Any remaining funds from the sale of the relinquished property are used to retire any debt or other expenses incurred by the EAT when it received title to the relinquished property or are transferred to the exchangor as boot. The sale of the relinquished property must occur within 180 days of the EAT’s initial acquisition of the property.
Improvement Exchange
From time to time, an exchangor may want to acquire replacement property and construct improvements on it during the exchange period. Such an exchange is referred to as an improvement exchange and can occur, for example, when the exchangor determines that the disposition of the relinquished property will generate exchange funds greater than the cost of the replacement property. This excess is used to fund the improvements on the replacement property. Thus, if the value of the improvements to be constructed during the exchange period plus the cost of the replacement property is equal to or greater than the funds generated from the sale of the relinquished property, an improvement exchange allows exchangors to defer the capital gains tax and recaptured any depreciation triggered when the relinquished property was sold.
The EAT holds title to the replacement property until a buyer for the relinquished property is found, while the exchangor manages construction operations on the replacement property. The exchangor can make payments directly to the general contractor or other vendor constructing the improvements, to be reimbursed by the EAT upon the disposition of the relinquished property. This allows the exchangor to engage contractors that require real time payments. Within five days of the transfer of the replacement property to the EAT, the EAT and exchangor must enter into a QEAA, which provides the terms and conditions of the exchange. Within 180 days of the transfer of the replacement property to the EAT, the exchangor must transfer the relinquished property to the buyer and the EAT transfers the replacement property to the exchangor.
The exchangor has 45 days to identify the improvements to be constructed on the replacement property after the relinquished property is sold to the buyer. The only property that will be considered to be “like-kind” for the purposes of the exchange is real property, or property that is attached to the land or structure. This is an important point, as material and labor are not considered real property. Thus, any materials must be affixed to the structure to qualify as real property and must be paid for during the exchange period, or when the EAT holds title to the replacement property. Since building materials cannot simply be delivered to the construction site but must actually be installed to qualify for 1031 exchange purposes, a key consideration for an exchangor is whether the general contractor or other entity constructing the improvements can complete a sufficient amount of improvements to the replacement property to defer all of the exchangor’s capital gains tax and depreciation recapture. Like all exchanges, an improvement exchange must be completed within 180 days, but the total construction does not need to be completed during that time. Construction on the improvements can continue after the 180th calendar day, though any such improvements will not defer capital gains tax.
Simultaneous Exchange
A simultaneous 1031 exchange occurs when the relinquished and replacement properties close at the same time. While on the surface this kind of exchange appears to be simple, issues can arise, particularly involving constructive receipt. Using STEC as a qualified intermediary for a simultaneous 1031 exchange will assure the exchangor that it will not constructively receive exchange funds and thus should preserve the preferential tax treatment of the exchange. In a simultaneous exchange, STEC will transfer the relinquished property to the proper entity, prepare various exchange documents and instruct the escrow/closing agent with respect to the disposition of sale proceeds. An exchangor must contact STEC prior to closing on the purchase and sale of the relinquished and replacement properties. An advantage to using STEC in a simultaneous 1031 exchange is that this kind of transaction can be easily converted to a forward or reverse exchange and eliminate the time pressure of trying to close the entire transaction simultaneously.