You have a property you want to sell, but you don’t want to pay a large tax bill. What can you try? It’s time to learn how to do a 1031 exchange.
Unfortunately, you can’t complete this process 100% independently. You will need someone to help you. However, you can take the majority of the crucial steps on your own, but take care to ensure you complete each step correctly. If you don’t, you can invalidate the entire process. Here’s what you need to know.
Why Consider a 1031 Exchange?
A 1031 exchange involves selling one property and rolling the associated tax liability into another investment. That purchase could be one, two, or more properties. However, what you buy and sell must be used for investment or business purposes. You can’t buy a new primary residence and expect to defer the taxes on the sale.
These transactions are complex, as they involve two properties that are deeply interconnected. It’s (arguably) much easier to simply sell one property and buy another. Straightforward sales and purchases can generally be done alone without professional guidance.
However, a 1031 exchange allows you to postpone the tax burden associated with the sale. If you never sell that property again—or you sell it via another 1031 exchange—you may never pay those taxes.
A 1031 exchange could also help to smooth your investment. For example, you could use a 1031 improvement exchange to use the proceeds from the sale of one property to make renovations on a replacement property. This type of transaction helps you improve the property while deferring capital gains tax.
How to Do a 1031 Exchange
As we mentioned, a 1031 exchange is a complex transaction with several moving parts. You can take plenty of these steps on your own, but you will need a little help with some of them.
These are the typical steps involved in a 1031 exchange:
1. Hire an Expert
Investors use 1031 exchanges to delay associated tax bills. To tap into these benefits, you can’t touch the proceeds of your sale. That means the money can’t come into your bank account, brokerage, or savings account. It must go to a third party (a qualified intermediary) who holds it for you until it’s time for the purchase.
To complete a 1031 exchange without losing your potential tax benefit, you must have a qualified intermediary to help you with the transactions. You can’t handle this part alone. If you do, you invalidate the transaction.
2. Sell the Property
With your qualified intermediary chosen and hired, you’re ready to sell the property. The funds from that sale should go to this organization (not into your personal bank accounts).
While you must use a qualified intermediary to hold the funds, you’re not required to hire someone to help you with the sale. Technically, you could sell your property as an individual. However, most people use a real estate agent for this particular step to ensure it’s done correctly in a way that most benefits them.
3. Identify a New Property (or Properties)
With one property sold, it’s time to figure out what to purchase. You may have plenty to choose from. Per IRS rules, you must choose a property that’s considered like kind. That means the items in the transaction must be real estate (not something like art), and they must be used for business or investment purposes (not as your personal residence).
You can find property to purchase independently. Scour online tools, head to open houses, and drive around promising neighborhoods. You could find just the thing you’re looking for and make an offer. You don’t need an expert to identify the property for you, but it’s a good idea to run it by them to ensure it meets the like-kind requirement.
4. Notify Your Team
When you’ve found the perfect investment, you must notify your qualified intermediary. The clock is ticking, as you have 45 days from the date you sold the property. Miss this deadline, and your plans for a 1031 exchange could evaporate.
Create a document that contains the address and a physical description of the items you’re planning to purchase. Be as clear as you can, and sign it. Give this document to your qualified intermediary. You can handle this step yourself, but just ensure you don’t skip it.
5. Complete the Purchase
When your property sells, the funds head to your qualified intermediary. When it’s time for the sale to close, those funds are transferred to escrow for the purchase. You can’t use these funds for things like debts or loans not related to the property without a tax penalty.
You have 180 days from the sale of the property to complete this step, and you can’t miss your deadline. If you’re efficient at real estate and know you can keep the sale on track, you can handle this yourself. Otherwise, you might need a realtor to put on pressure and ensure the sale goes through.
6. Complete the Paperwork
The tax liability from your sale doesn’t disappear in a 1031 exchange. It’s just deferred to the property (or properties) you’ve purchased. The IRS will keep track of your profits and how you’re using the purchase.
Paperwork is critical. You must fill out associated forms at tax times. You can fill these documents out yourself, or you can ask your accountant to help.
Can You Do This Alone?
Unfortunately, you can’t handle a 1031 exchange all by yourself. You need a qualified intermediary to take charge of the financial aspects of the sale and the purchase. And it’s worth it to have an expert guiding you through other parts of the process to ensure you get it right. One of your most important jobs is to find the right helper.
At 1031 Pros, we help investors just like you with delicate 1031 exchanges. We can provide you with the assistance you need to ensure you’re not hit with a big tax bill down the road. Our experience can be invaluable as you look for ways to diversify your portfolio and make the most of your investments. Contact us to get started today.
References
Like Kind Exchanges: Real Estate Tax Tips. (November 2023). Internal Revenue Service.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Exchanges Under Code Section 1031. American Bar Association.
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