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1031 exchanges are tax-deferred techniques that enable property owners to sell and make reinvestments into structures while deferring the capital gains taxes. The latter is a 1031 exchange where you swap properties basically held for investment or used in your business for another piece of business or investment real estate that is like kind. A 1031 exchange complies with section 1031 of the United States Internal Revenue Code. Find out more about this in the blog below.
Steps to Draft a 1031 Exchange
To successfully execute a 1031 exchange, follow these steps:
- Identify the Property that You Want to Sell. Generally speaking, this kind of exchange applies mostly to commercial or investment properties as opposed to personal holdings such as small residences or vacation homes, which are not eligible for 1031 exchange.
- Check if “Like-Kind” is Met on Properties. In selling and buying, for them to be referred to as being like kind they should have a similar nature, character, or class. However, it is important to note that property inside the United States cannot be compared with real estate rights outside the country.
- Select an Able Intermediary. It is vital for a smooth 1031 exchange process to work with a capable third party known as an exchange facilitator. They keep money in escrow until after the transaction when you receive your funds so that you do not get paid before they become due. Caution should be exercised in order not to incur financial losses or miss deadlines.
- Allocate Selling Earnings for the New Property. Whether to reinvest all of the sales proceeds into another similar property is optional; only that part reinvested qualifies for capital gains tax deferral. Alternatively, you may have to pay capital gains tax immediately if some of your sale proceeds are retained by you.
- Abide by Strict Timelines. Failure of two deadlines will result in subjecting the profit earned from your sale of real estate to tax. Within forty-five days after disposing of your own property, you must complete the identification of potential lands and notify either the seller or your qualified intermediary through writing. Subsequently, at least 180 days must elapse after the sale of your previous land before purchasing new or, in any case, the tax return filing deadline, whichever comes first within these limits, does occur.
- Concentrate on Allocating Funds. To avoid paying taxes on any income derived from selling, it is important to keep in mind that you must not receive the money or any other gains from the transaction before the completion of the swap; otherwise, the contract may collapse and your gain taxed immediately.
- Explain transactions to the IRS. During the tax filing period, you need to file your Form 8824 with the IRS. This form will require you to provide details about these properties, give a chronology of this exchange process, identify parties involved, and submit financial information.
Key Points Affecting 1031 Exchanges
While entering into a 1031 exchange, consider the following:
- Tax Paying is a Must: As much as 1031 exchanges defer capital gains tax, it does not absolve you from paying it entirely. Knowing that, at some point in time, you will have to pay the taxes of capital gains helps in proper preparations.
- Different Property Features are Possible: For instance, “like-kind” does not mean the same copy of the property exchanged. Normally, it means exchanging one investment property for another – for example, undeveloped land with a business building.
- Relationships are Important: It should be noted that no relative, lawyer, banker, employee accountant, or real estate agent can act as your qualified intermediary or exchange facilitator. You are also banned from dealing with those who occupied any of these positions on your behalf within two years. It is forbidden to act as your intermediary.
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Types of 1031 Exchanges
There exist three distinct types of 1031 exchanges:
- Simultaneous Exchange: In this case, the buyer and seller trade properties at once.
- Deferred Exchange: In delayed exchanges, buyers and sellers conduct trades between assets at different times but note that selling one and buying another must be ‘mutually interdependent parts of an integrated transaction’. This area may get complicated, so seeking advice from a tax expert is highly recommended.
- Reverse Exchange: New property is bought before the old one is sold in reverse exchange cases. At times, there might be an ‘exchange accommodation titleholder’ holding onto the new property for up to 180 days while the former property is disposed of.
Rules to Choose Replacement Property for a 1031 Exchange
It is very important to make a good choice of properties that can replace each other for 1031 exchanges to succeed. Find some main rules below:
- Flexible Property Identification: ‘Like-Kind’ can be interpreted in many ways, such as an exchange of vacant land for a rental house or changing one commercial property into an apartment. All are eligible as long as they are used in any profit-making activity.
- Checking for National Property Qualification: The geographical location of the replacement property does not matter. Hence, if you want to sell a New York property and buy another one in California, then you can swap properties anywhere within the USA.
- Several Properties May be Included in One 1031 Exchange: This entitles you to sell off one property and thereafter buy up to four other properties meant for either trade or investment using proceeds generated therefrom.
- Comparing Prices of Replaced Properties: To enjoy full deferral on all capital gains tax liability, the new property’s cost should be equal to or greater than what was received upon sale. If its value is lower, however, all differences will be taxed at normal rates.
Key Terms for 1031 Exchanges
- Qualified Intermediary: This is a third party who will help in the process of exchange by selling your property and keeping your money in an escrow account until you are ready to buy another property.
- IRS Form 8824: This paper calculates deferred gain amount through a like-kind exchange.
- Boot: It can be defined as cash or non-like-kind properties received during a 1031 exchange that was not invested into the new replacement property. Generally, the boot is taxable as capital gains.
- Identification Period: Usually, identification periods last 45 days from the date of sale of relinquished properties. You must identify possible replacement properties within this period for completion of the process.
- Delayed Exchange: The most common type of 1031 exchange is the Starker or deferred exchange. In this type, the qualified intermediaries arrange to acquire replacement property after the sale of the relinquished property.
- Reverse Exchange: The reverse exchange is when you buy a replacement property before you dispose of your relinquished property. It involves the mechanism of using an Exchange Accommodation Titleholder (EAT), whereby such buyer holds the title to replacement property on behalf of the seller until the last such seller finds a buyer for his relinquished property.
- Capitalization Rate: It depicts the required return associated with any real estate investing.
Final Thoughts on 1031 Exchanges
For successful completion of the 1031 exchange, some various requirements and regulations have to be taken very religiously. Just one wrong move may jeopardize the whole exercise and land one in a hefty tax bill. Therefore, engaging professionals in the entire transaction when getting one's plan ready for the 1031 exchange is of the essence.
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ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.
