Title Insurance Can Be ‘A Little Tricky’ in Certain 1031 Exchanges

Although this blog is avowedly apolitical, with the results of the recent election, it seems likely that one of the most significant tax benefits for real estate investors will remain intact – the 1031 exchange.

A properly structured 1031 exchange allows a seller of real estate to defer taxes on capital gains on the sale of real property by exchanging the sold property for another property.  Through a 1031 exchange, the seller avoids the recognition of gain until there is a taxable disposition of the property.  If the seller dies while owning the property, the seller’s heirs take ownership of the property with a stepped-up basis, and the gain associated with the seller’s period of ownership is never taxed.investor-image

A seller is not required to simultaneously exchange properties to obtain the tax benefit.  Deferred exchanges are possible, subject to certain and inflexible rules.  These rules include the time periods in which to identify and acquire the replacement property and how to handle the sale proceeds.  There are special rules for many different exchange scenarios, including build-to-suit exchanges, related party exchanges and reverse exchanges.  If sellers fail to comply strictly with all of the rules, they will not have a valid deferred 1031 exchange and will have to pay capital gains taxes (and maybe even interest and penalties).

Title insurance can get a little tricky in certain 1031 exchanges.  In a basic “forward” exchange, where the seller sells the relinquished property first and acquires the replacement property second, title is passed in what is known as “direct deeding.”  The deed for the sold property goes from the taxpayer to the buyer and the deed from the seller of the replacement property goes directly to the taxpayer.  Title does not have to pass through a third-party qualified intermediary.  This process allows for issuance of title insurance policies to the real seller and buyer at the closing of the particular transaction.

The process is different in a “reverse” exchange or in certain “build to suit” exchanges that can be structured as a reverse exchange.  The taxpayer acquires the replacement property first, but there is no “direct deeding.”  Under the rules, the taxpayer cannot actually acquire title while holding title to the relinquished property.  The taxpayer uses an Exchange Accommodation Titleholder (EAT), who holds title to the replacement property until the sale of the relinquished property is completed.

In this structure, the proper “owner” to be insured in an owner’s title policy is the EAT, as the holder of title.  The taxpayer is not the proper insured until the taxpayer acquires title to the replacement property from the EAT.  In New Mexico and most states, the taxpayer will need to obtain two separate title policies.  There may be discounts available that help with the cost of the second policy.

To learn more about 1031 exchanges and the value they provide, please visit the website of Asset Preservation, Inc., Stewart’s 1031 exchange affiliate. This blog tries to highlight some of the issues parties face when considering an exchange.  It is not legal advice; interested parties should consult their own attorney, tax advisor or accountant to determine options appropriate to their circumstances.

If you, your customer or your client is doing a 1031 exchange, please consider working with your title company early in the process to understand how title to the different properties will need to be insured and how you can obtain the best combination of coverage and cost.

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