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Building a Team to Capitalize on 1031 Exchanges
Investors should approach the process with a clear understanding of IRS regulations.
With nearly $1 trillion in commercial real estate loans maturing this year, as reported by S&P Global, a wave of distressed properties is expected, while historic lows in construction starts and supply constraints could drive long-term potential for property value growth. For investors looking to reposition their portfolios, defer capital gains taxes and capitalize on resilient asset classes or high-growth markets, 1031 exchanges can provide a pathway.
Since the 1920s, 1031 exchanges have supported economic growth by allowing tax deferral on reinvestments in like-kind properties. Despite stubbornly high interest rates, 1031 exchanges offer real estate investors flexibility that traditional debt financing often cannot match, enabling buyers to secure opportunities now and refinance under better conditions later. To assist them in making informed decisions and maximizing the benefits of 1031 exchanges, investors can consider engaging a team of professionals consisting of lawyers, tax advisers, real estate experts and qualified intermediaries.
Streamlining the Process
Navigating the applicable rules and regulations can be overwhelming for a first-time 1031 exchange investor. A qualified intermediary or "QI" simplifies and streamlines the process by providing the necessary resources and framework to document the exchange.
A key requirement for a successful exchange, as outlined in the Treasury regulations (26 CFR Sec. 1.1031(k)-1), is avoiding actual or constructive receipt of funds from the sale of the relinquished property. Constructive receipt occurs when the taxpayer has control of or rights to the funds, even indirectly. To prevent this, a QI establishes a "safe harbor" exchange, shielding taxpayers from constructive receipt through an agreement that restricts their access to proceeds during the exchange. This safeguard offers significant value by supporting compliance while reducing uncertainty.
IRS rules prohibit "disqualified parties" from acting as a QI for a taxpayer. These are parties who have performed services for the taxpayer anytime during the two-year period prior to the date the relinquished property was sold, unless those services are limited to the client's 1031 exchange. Therefore, a QI company provides a service that many taxpayers' trusted contacts — including their attorney, their employees, their investment banker or broker, a related party or anyone with an agency relationship to the taxpayer — usually cannot.
The QI also coordinates all required documentation, provides informational resources, guides the client through the 1031 process and points out potential issues or risks. At the time of sale of the taxpayer's relinquished property, the QI is assigned into the contract between the taxpayer and the buyer and assumes all seller's rights under the contract to receive payment for the property from the buyer. The QI then instructs the person preparing the transfer deed to directly deed the property from the taxpayer to the buyer. However, the QI directly receives the funds from the closing of the sale. All instructions and documentation necessary for this portion of the exchange, along with coordination of the 1031-related components of the sale, are prepared and conducted by the QI (with assistance from any of the taxpayer's chosen tax advisers, attorneys or real estate agents) at, or prior to, closing.
When it is time for the taxpayer to acquire their replacement property, the QI is assigned into the contract between the taxpayer and the seller, assuming buyer's rights to acquire the property and the buyer's obligation to fund the acquisition. The QI is then able to fund the purchase and instructs that the property be deeded directly from the seller to the taxpayer. The QI handles documentation and coordination of this step of the exchange, as well as documentation of the taxpayer's completion of the exchange.
Attorneys Acting as Closing Agents
In some regions of the United States, attorneys often act as closing agents for real estate transactions, handling funds during the process. However, under IRC Section 1031, taxpayers must avoid actual or constructive receipt of proceeds from the sale of the relinquished property. If an attorney serves as the closing agent, involving a QI to manage exchange funds is important to preserve tax-deferral benefits.
Attorneys should not act as the QI if they provided services to a client within the two years preceding the exchange, except for 1031-specific assistance. To comply with IRS rules, attorneys can use independent escrow companies or title insurance underwriters to handle exchange funds. If an attorney continues as the closing agent, the QI can send exchange funds directly to the seller or use a neutral third party, such as a title company or escrow agent, to manage disbursements.
The Role of the Tax Adviser
There can be significant crossover in what attorneys and tax advisers provide in the way of assistance to taxpayers, so they are sometimes lumped together and referred to as "tax advisers" when discussing 1031 exchanges.
That said, investors should consider several specific factors when working with tax professionals. A tax professional can help determine the tax basis of the property being exchanged, identify the tax consequences of exchanging or not exchanging a property, and help explore alternative options that may be helpful in the investor s particular situation. For foreign investors, this includes guidance and assistance with issues related to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
A tax professional can also advise on whether the property meets the qualified use test — for example, determining if the property is technically held for investment. This is often straightforward, such as with a rental property, but it can get more complicated if the property is a part-time vacation home or personal-use property, or if only a portion of the property was used for investment purposes. A tax professional can counsel on whether these uses are sufficiently documented for exchange eligibility.
Throughout the exchange, a tax adviser can provide professional opinions on gray areas or questions that lack explicit IRS guidance, helping the investor to make more informed choices. And at tax filing time, a tax professional can review all exchange documentation, prepare the paperwork and file taxes to properly report the exchange.
Julie Baird is president of First American Exchange Company, a national qualified intermediary owned by First American Title Insurance Company.
Nothing contained in this article is to be considered as the rendering of legal or tax advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel or tax professional. This article is intended for educational and informational purposes only.
