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In my work with #1031 exchanges (as both a qualified intermediary and a real estate professional), I often encounter investors who are delving into the world of 1031 exchanges for the first time. They understand the basic concept of trading investment property to avoid capital gains taxes, but are a little fuzzy on the steps of the process.

One of the biggest things any investor must know before beginning any 1031 exchange is how the IRS treats the cash from the sale of the relinquished property. In order for the exchange to be valid, the very first hurdle is making sure the investor never has actual or constructive access to the sale proceeds.

That is where the role of the qualified intermediary (QI) comes in. The proceeds from the sale of the relinquished property must be held in escrow by an independent, third-party (the QI). If, at any time, the investor obtains the funds – or even borrows against them or in any other way benefits from the assets – then the tax-deferred nature of the exchange is in jeopardy. Most likely, the entire exchange will be invalidated.

This is an important fact to understand, because it points out the necessity of finding and retaining a competent QI long before you begin your exchange. If you wait until after you close on the sale of your relinquished property, it will be too late. You will “have” the sale proceeds (even if you don’t cash the check) in the eyes of the IRS. Any chance for a successful exchange are pretty much extinguished at that point.

Presuming you met the burden of not having access to the sale proceeds, when you get ready to close on the replacement property, the QI will wire the funds to the seller and you will then get title to the new property. This is the safest approach to a legitimate 1031 exchange.

If a 1031 exchange is in your future, visit our website to learn more about these powerful tax deferral tools and our qualified intermediary and replacement property locator services.

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