The Best Deeding Method to Use in 1031 Tax Deferred Exchanges

In this article, I'd like to define two real estate termsdirect deeding and sequential deedingand show the best form to use with 1031 Tax Deferred Exchanges.

If you're not familiar with the "1031," this law allows the exchange of investment or business property for other investment or business property, without paying tax (it's deferred) if the property received is "like kind."

As you'll see below, direct deeding is the better choice in this situation, but it's important to understand the difference between the two options so you're armed with full knowledge when you enter into a 1031 Exchange.

Direct Deeding and Sequential Deeding

Direct deeding is a process of deeding property directly to the buyer rather than to an intermediary (the initial common method in 1031 tax deferred exchanges). The seller of the property deeds his or her property directly to the buyer, skipping the deed to an intermediary.

In 1990, the IRS ruled that it was no longer necessary to use "sequential" deeding in a tax-deferred exchange transaction. With the sequential deeding method, the seller's deed is given to an intermediary who then deeds the property to the buyer.

Most property transfers in tax-deferred exchanges today use "direct deeding" rather than "sequential deeding."

The Advantages of Direct Deeding Over Sequential Deeding

Under sequential deeding, the intermediary is exposed to the risk of liability (asbestos, environmental hazards, etc.) for the short time they hold title. Direct deeding reduces those risks.

Another advantage of direct deeding is cost savings. It eliminates the payment of duplicate transfer taxes which are normally charged each time a deed is recorded.

Safeguards To Follow in the Direct Deeding Process

It's a necessity to use a fully qualified intermediary. Check ahead of time so you know that the intermediary is qualified and has experience. You definitely don't want a "newbie" or an incompetent handling a 1031 transaction.

As a seller, ensure that the intermediary has an agreement with your buyer for the transfer of the property to be exchanged.

As a buyer, make sure that the intermediary has an agreement with the seller of the property which allows for the transfer of that replacement property to you.

Additional Information On Intermediaries

All parties to the agreement must be notified in writing of your intention to use an intermediary in the exchange. In typical cases, the qualified intermediary in your exchange is affiliated with a title or escrow company. The title or escrow company provides all the services required to handle the closing; e.g., title insurance, escrow services, and document preparation and transfers, etc.

There are several advantages to using a professional intermediary in a 1031 exchange, including:

Reduction of the potential liability for the structure of the exchange and any tax consequences.

Shielding of the principals from accepting additional liability.

Provision of a paper trail by way of the assignments and exchange agreements.

The 1031 Tax-Deferred Exchange is a great mechanism for deferring taxes. However, it can be a complicated process, so it's best to be fully-informed on these transactions.

Key Point: If you're new to 1031s, absolutely seek the advice of a tax professional who's experienced in exchanges!

Jack Sternberg