Understanding 1031 Exchanges - 10 easy steps!
Under section 1031 of the US International Revenue Code, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a 1031 exchange. Understanding the process up front is important to your success.
1. Decide if a 1031 exchange is right for you.
Not every investment sale and purchase is worth doing a 1031 exchange. With all of the costs, requirements, and time deadlines, simply paying the tax and moving on may be advantageous in some circumstances. That is definitely a discussion for you to have with your accountant or tax professional.
2. List your current investment property for sale.
You then list your property for sale, as you ordinarily would. Your Real Estate Broker will include language in the listing paperwork regarding your desire to do a 1031 exchange and the buyer's requirement to cooperate. Be sure to choose a real estate professional with experience in 1031 Tax Deferred Exchanges!
3. Begin looking for replacement properties.
Keep in mind that the moment the relinquished property is sold (closed), the 45-day countdown to formally identify your replacement property begins. Therefore, your Real Estate Broker should help you start looking for a replacement property immediately.
4. Find a qualified intermediary.
Look for a solid, professional, reputable company. Be careful!
5. Negotiate a contract with a qualified Buyer.
When someone agrees to purchase your property, you will need to make sure the paperwork clearly states that you will be participating in a 1031 exchange, and that the Buyer agrees to cooperate (at no cost or consequence to them - but there is paperwork they will be required to sign).
6. Close on the sale of your relinquished property.
The title company will handle the closing, as with any other real estate transaction, except that your qualified intermediary will be actively involved in the process, and the funds will transfer to their bank account, not yours. You are NOT allowed to "touch" the money (as that would invalidate the exchange.)
7. Identify up to three potential replacement properties within 45 days of the closing of your sale.
Within 45 days of the closing of your relinquished property you must officially designate the property you intend to purchase. Keep in mind, you can identify up to three properties, or more if you close on 95% of them or the total combined value of the identified properties is less than 200% of the sales price of your relinquished property. You MUST identify the potential replacement property within that 45 days. You have up to 180 days to close on the replacement property (including the 45 days) and complete the exchange from the date that your relinquished property closes escrow.
8. Make an offer on a potential replacement property.
Of the properties you identify, typically one will stand out as your first choice. You will need to get that property under contract and open escrow, making sure the Seller knows you are purchasing through a 1031 exchange (and that they agree to cooperate with the process and sign the necessary paperwork). You do not actually have to wait until your relinquished property closes escrow to begin this process, as long as your Real Estate Broker includes the proper contingency language in your offer.
9. Your qualified intermediary will work with the title company.
You, your Real Estate Broker, and your qualified intermediary will work with the title company to make sure that all of the paperwork is completed properly.
10. Close on the replacement property.
The qualified intermediary will wire your money to the title company, and the property will close as in a normal transaction, deferring your need to pay the taxes. You can actually repeat this process over and over again on properties and continue deferring taxes indefinitely. This can help you build wealth over time.
A 1031 exchange is not always recommended for everyone. It is a way to defer tax and potentially eliminate taxes in the long run. Therefore, long term planning is key in deciding whether an exchange is right for you. Be sure to consult your tax planning professional!