A 1031 exchange is an excellent way to diversify or switch up your real estate investment portfolio while avoiding an immediate tax bill. However, 1031 exchange requirements are strict. If you deviate from these rules, you risk voiding the transaction.
We’ll explain everything you need to know about the rules and requirements, so you can decide if this approach is right for you and your business.
What Is a 1031 Exchange?
Before we dig into 1031 exchange requirements, let’s revisit what this type of transaction is and what is involved. Then, you can decide if a 1031 exchange is a good idea.
Like a traditional real estate deal, a 1031 exchange involves selling one property and purchasing another. As a business that deals with real estate, you may have conducted several of these transactions throughout your lifespan.
However, a 1031 exchange allows you to wrap up the taxes associated with the sale of a business into the purchase of a new one. As the IRS explains, these complex transactions involve mutually dependent parts. The disposition of one property and the acquisition of the next are linked.
If you follow the 1031 exchange requirements, you can do things like sell an underperforming property, tap into a different market, or switch to a different location. You can do all of this without paying capital gains as soon as the sale is complete.
1031 Exchange Requirements You Should Know
These are the rules and regulations you must follow to complete a 1031 exchange without facing a large and immediate tax bill. Follow these rules closely to ensure your transaction isn’t at risk:
Hire a Qualified Intermediary First
Before you consider a 1031 exchange, hire someone to act as your qualified intermediary. This professional or organization can guide you through the entire process. Importantly, this person can also hold (or park) the proceeds of the sale of one property and release it when it’s time to purchase another. You must hire this person early, long before the sale is complete. That means it’s smart to choose your intermediary as a first step.
Don’t Work as Your Own Intermediary
Plenty of investors are adept at handling real estate transactions. Some have already used 1031 exchanges to diversify. It doesn’t matter how much you know about these transactions or how often you’ve handled real estate in the past. Per IRS rules, you can’t work as your own qualified intermediary. You must hire someone to do this work for you.
Identify the Right Properties
The IRS explains that both properties involved in a 1031 exchange must be used for business and an investment. Items primarily used as personal residences aren’t eligible for these exchanges.
In other words, you can’t sell your primary residence that you’ve lived in for 10 years for a rental home within an exchange. Both properties must be primarily used for business purposes.
Similarly, the IRS requires that both properties must be considered like-kind. That means they’re of the same nature, character, or class. Quality or grade is immaterial. Most real estate is like-kind to other real estate, but exceptions exist. For example, you can’t include properties from two different countries in an exchange.
Try to Buy Up
Get the most from your 1031 exchange by purchasing a property that’s worth more than the one you’re selling. If you can’t make that happen, purchase two properties as part of the exchange. Downsizing your investment can mean facing some tax problems that could make the sale less profitable.
Don’t Touch the Money
A 1031 exchange can be a long and drawn-out process (more on this in a minute). While it might be tempting, taking control of cash or other proceeds before the exchange is finished can make all gain immediately taxable, the IRS says.
If you’ve followed the rules we explained earlier, the proceeds from the sale will be safely held by your qualified intermediary. That entity should not release any of the funds to you for any reason.
Meet the Deadlines
The IRS sets two very important deadlines for 1031 exchanges. They can’t be extended for any circumstance other than a presidentially declared disaster. Those deadlines are as follows:
45 days: From the moment the sale of one property is complete, you have 45 days to identify (in writing) the other property involved in the exchange.
180 days: From the moment of the sale, you have 180 days to complete the purchase of the other property.
There are plenty of hidden ways to break these rules. For example, you must provide written identification of the property to your qualified intermediary. Writing an email to your real estate agent won’t be enough to meet this requirement. Take care to make sure you are completing these steps correctly.
Use the Same Buyer & Seller
This requirement seems pretty straightforward, but it’s important to mention. Both the official buyer and the official seller within a 1031 exchange must be the same person. You can’t do something like list your wife as the seller of one property and yourself as the buyer of the other property in the exchange. The name must be exactly the same on all official documents.
Share With Related Parties With Care
In most cases, you can’t purchase a property from a relative as part of a 1031 exchange. Instead, you must consider this an arm’s length transaction that’s between two people who don’t owe one another anything.
Don’t Forget the Taxes
Some people mistakenly believe that a 1031 exchange wipes away their capital gains tax obligations. This isn’t true. As the IRS explains, gain in a 1031 exchange is deferred, but it’s not forgiven.
If you know you won’t hold the purchased property for a long period, keep track of the basis in your new property. When this item is sold, the original deferred gain and any other gain you’ve realized since the purchase are taxable.
You can avoid this issue by using another 1031 exchange when it’s time to divest. But it’s important to remember that those tax burdens exist, so when the bill comes due, you’re ready for them.
Report the Exchange
During the tax year in which the exchange occurred, you must report the transaction to the IRS. You’ll use Form 8824 and file it with your tax return for that year. If you skip this step, you could be subject to an audit and potential fines. You may need an accountant to help with this step, as the required documentation is complex.
Consider a 1031 Exchange
Plenty of real estate investors want to diversify, alter, or otherwise mix up their holdings. A 1031 exchange is an exceptional option. However, you must follow all of the 1031 exchange requirements to take full advantage of this opportunity. Ensure that you’re working with an expert to avoid bumps along the way.
At 1031 Pros, we specialize in 1031 exchange transactions. With our streamlined process, you can avoid immediate tax burdens, ensure compliance, and keep your investments in your business where they belong. Contact us to get started today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Like-Kind Exchanges - Real Estate Tax Tips. (November 2023). Internal Revenue Service.
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