You have one or two properties, but they aren’t quite right for your investment portfolio. You want to sell them, but you’re worried about the tax consequences. What can you try? Consider a 1031 exchange.
With this method, you can transfer the associated tax burden from one property to another. In other words, you can sell one property in exchange for another and avoid a big bill at tax time.
So how does a 1031 exchange work? Understanding the rules, regulations, and steps is critical. Here’s what you need to know.
What Is a 1031 Exchange?
A 1031 exchange is a real estate transaction involving two investment properties. The technique is named after the Internal Revenue Code that outlines its rules and regulations.
In a 1031 exchange, you trade an investment property for another that’s considered “like kind” by the IRS.
In a transaction like this, you sell one property and pick another that’s to be used for an investment. In essence, you roll your investment into a new property.
Why Should You Consider a 1031 Exchange?
A 1031 exchange is complex, and it requires outside help. In many ways, it’s simply easier to sell a property and buy another independently. However, a 1031 exchange comes with plenty of advantages you should consider.
Per IRS rules, you’re not required to recognize a gain as part of a 1031 exchange. That means you don’t have to pay capital gains on the sale of your investment property, which could help you keep the hard-earned money you’ve made from maintaining a property.
You also won’t have to worry about things like depreciation and gap payments. Your obligations simply roll over to the new property, and they won’t become due until you sell the replacement property.
Most people enter the real estate investment market because they want to make money—not to give it to the tax collector. A 1031 exchange could make this possible.
How Does a 1031 Exchange Work? Steps from Start to Finish
Now that you know what a 1031 exchange is, it’s time to dig into the details involved in these complex transactions. Here are all of the steps involved:
1. Hire a Qualified Intermediary
Per IRS rules, someone participating in a 1031 exchange cannot take control of the cash or proceeds before the exchange is complete. If you do take possession, the funds are immediately taxable, potentially wiping out all the benefits involved.
A qualified intermediary—typically a company that focuses on these transactions—accepts the money from the sale and holds it for the purchase of the replacement. You never touch the money, so you’re in compliance with the rules. If you handle the funds, it could negate the entire 1031 exchange, meaning it will be treated as a taxable property sale.
2. Sell Your Property
With a qualified intermediary identified, you can list your property for sale and let that transaction proceed normally. The funds from this sale should go directly to the organization you’ve tapped to help you with the 1031 exchange.
3. Hold Your Funds in Trust
Your qualified intermediary can’t cut you a check for your profits or take a loan on the money. Instead, this organization simply keeps the funds for you in an account. You can use that money to buy a replacement property.
At this point, the clock starts ticking. You have two very important deadlines to meet for your 1031 exchange, and Day 1 is the day your sale is complete.
4. Search for the Perfect Exchange Property
Your replacement property must be similar to the one you’ve sold, and it can’t be something you plan to use as your primary or vacation home.
The IRS defines like-kind property (the only kind of property you can purchase in a 1031 exchange) as something of the same nature, character, or class as the one you’ve sold. Quality or grade doesn’t matter, but location does. You can’t buy something that exists outside of the United States.
Many investors use 1031 exchanges to buy properties that are similar to those they sold. For example, if you have an apartment building, you might use these transactions to purchase another apartment building.
However, you can use these transactions to buy something completely different too. For example, you could trade an office building for an apartment building. The IRS says most real estate will be like-kind or other real estate. If you’re unsure what constitutes like kind, it’s worth it to consult a professional who specializes in 1031 exchanges.
5. Identify (In Writing) Your Replacement Property
You have 45 days from the date you sold your property to identify potential replacements. Just picking the property isn’t enough. That selection must be formally outlined in a document you share with your intermediary.
The identification must include these items:
The location and details of the replacement property
The intermediary you’re using
Your signature
You can’t send this document to someone like your attorney or your real estate agent and consider this done. Instead, you must give it to your intermediary and/or the person selling the property. Remember to keep a copy for your records.
This is an easy step to skip, and unfortunately, many people do so. Remember that you must complete this paperwork to ensure that your 1031 exchange is moving along properly.
6. Complete the Purchase
You have 180 days from the date your original property was sold to close the purchase on the new one. That means wrapping up all of the final paperwork and taking possession of the new one.
Real estate transactions can be complicated, and finishing up a sale isn’t easy. But you can’t extend this deadline and keep the tax benefits of a 1031 exchange. Sticking to your time frame is critical to ensure things proceed as they should.
7. Notify the IRS
Your tax obligations aren’t wiped away in a 1031 exchange. Instead, they’re deferred to a future date. That means you must keep the IRS apprised of all of the steps you’ve completed and what they can mean to you.
In the tax year of your exchange, you must file forms accordingly. These forms are complicated and easy to get wrong, so most people use an accountant to help with this important step. In some cases, a qualified intermediary can help with this as well.
Get Help With Your 1031 Exchange
Don’t be overwhelmed with all of the steps involved with a 1031 exchange. Instead of trying to become an expert on these matters yourself, hire someone with plenty of experience and a willingness to help you.
At 1031 Pros, we’ve helped thousands of investors complete 1031 exchanges like this. We can ensure that you stick to the required time frames and don’t miss any important steps in the process. Contact us to find out what we can do and how we can ensure your transaction moves smoothly.
References
The 1031 Exchange Rules You Need to Know. (January 2023). Kiplinger.
Like-Kind Exchanges: Real Estate Tax Tips. (November 2023). Internal Revenue Service.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Like-Kind Exchanges Are Now Clearer. (October 2020). Journal of Accountancy.
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