What to Know Before the 1031 Process Begins

Many investment property owners?take advantage of 1031 exchanges as a tax-deferral strategy. A 1031 exchange allows real estate investors to sell properties for like-kind properties and defer capital gains tax on the sale. A successful 1031 exchange can free up cash, allowing investors to benefit from different real estate opportunities.

If you’re interested in the opportunity a 1031 exchange presents, you should understand some critical information about the 1031 exchange process. This guide summarizes what to know before a 1031 exchange, including specific rules that apply and what benefits and drawbacks you might expect from the exchange.

What Is a 1031 Exchange?

A?1031 exchange?is a type of real estate property exchange outlined by?Section 1031 of the Internal Revenue Code?(IRC). Also called a like-kind exchange, a 1031 exchange allows real estate owners to use the proceeds from the sale of an investment property to purchase another property or properties, as long as the new properties are of equal or greater value than the relinquished property. A 1031 exchange also allows the real estate owner to defer capital gains taxes on the sale.

According to the Internal Revenue Service (IRS), properties are considered like-kind if they are of?the same character or nature. Most real estate properties used as an investment are?like-kind to other properties, even if one is an apartment complex and the other is a retail building. The IRS also limits these properties to those used for business or trade or held as an investment. For instance, taxpayers cannot perform a 1031 exchange to swap their personal vacation home for another property.

There are no limits to how many times taxpayers can perform 1031 exchanges, allowing them to defer taxes on each swap until they decide to sell the newest property for cash. If performed correctly, the taxpayer can pass the property on to their heirs at a step-up in basis.

A 1031 exchange allows real estate investors to grow their investments tax-deferred, building wealth and disposing of real estate investments to acquire different ones. Taxpayers may also choose to sell their current property before purchasing a new one or swap the properties at the same time, which is called a?simultaneous 1031 exchange.

What Is a QI, and Do You Need One?

A?qualified intermediary?(QI), also known as a 1031 accommodator or facilitator, is a professional who oversees the 1031 exchange process. All exchange transactions must be completed with the assistance of a QI. The taxpayer completing a 1031 exchange should select a reputable QI to ensure the process follows all 1031 exchange rules.

The purpose of a QI is to help you navigate the complicated 1031 exchange process and comply with all the code’s regulations and requirements. If a taxpayer completing a 1031 exchange doesn’t follow all rules, the IRS can invalidate the exchange and present them with an unexpected tax bill. Unless every requirement is met for the disposition and acquisition transactions, a real estate owner could pay capital gains taxes on their sale.

A primary function of QIs is to restrict the investor’s access to the proceeds of their sale of the relinquished property. By deferring the receipt of their income, taxpayers can defer capital gains taxes on the exchange. The QI acts as an escrow holder for the funds to prevent a taxable event through the investor’s actual or constructive receipt of the income.

The QI performs pivotal roles in 1031 exchanges, including holding funds from the sale of the relinquished property in an escrow account. Yet there are no federal regulations regarding the industry, making?selecting the right QI?a crucial task. A QI must be an independent entity that is not the investor, the investor’s agent, or related to the investor. A QI also enters into a written agreement with the investor to complete the exchange transactions on their behalf to ensure the process adheres to 1031 real estate exchange requirements.

What Qualifies for a 1031 Exchange?

Properties must meet several criteria to qualify for a 1031 exchange. The following lists the specifications for properties bought and sold in the 1031 exchange process:

• The like-kind rule:?The relinquished and replacement properties in a 1031 exchange must?qualify as like-kind. The IRS specifies that like-kind properties have the same nature or character, regardless of their quality or grade. This rule allows many different kinds of real estate to be considered like-kind. For example, a duplex may be exchanged for an industrial building. All property must be in the United States.
• The productive use rule:?Only properties held by the taxpayer for productive use in business or trade or held as an investment can qualify for 1031 exchanges. However, some?modifications to the rules?regarding 1031 exchanges allow investors to perform an exchange with properties that were once for personal use but are now for productive use.
• Property values:?The net market value of the replacement property or properties in a 1031 exchange must be?equal to or greater than?the value of the relinquished property. This sum includes the total equity, debt, and profits from the sale of the property and expenses like commissions and fees for QIs, real estate agents, and brokers. QIs might charge additional fees or commissions depending on the investment selected.

What Does Not Qualify for a 1031 Exchange?

Investors may also consider what characteristics can disqualify properties from being eligible for a 1031 exchange:

• Properties that are not like-kind:?The IRS will disqualify a 1031 exchange if the properties are not like-kind. For example, domestic properties may not be exchanged for international properties. The IRS also?specifies that exchanges of machinery, artwork, collectibles, and other intangible property are disqualified from 1031 exchanges.
• Personal use:?Because properties must be in productive use to qualify for a 1031 exchange, any properties in personal use, like the investor’s?primary residence?or vacation home, do not qualify.
• Property values and purpose:?If the replacement property’s value is less than the relinquished property’s, the investor must?pay capital gains on the boot. Investors should also be aware that real property?held primarily for sale?also does not qualify for a 1031 exchange. This category includes real estate that is going to be remodeled and sold.

Fees, Costs, and Charges of a 1031 Exchange?

Investors will experience several different costs and charges in the 1031 exchange process. The cost to complete the process varies depending on the number of properties involved, the exchange company, and possibly the properties’ location. Taxpayers must consider the following costs before beginning a 1031 exchange:

• Setup and administrative fees:?A QI charges setup and administrative costs to cover the risk to which the exchange exposes them. QIs typically charge a property administration fee for each property in the exchange. Other fees cover the cost of administrative work for the 1031 exchange.
• Interest income:?Investors may earn interest on the 1031 exchange funds, although QIs will retain a significant amount of the realized interest from the funds while the QI holds them.
• Incidental?costs:?Investors may pay additional fees in certain situations, such as overnighting a check. Attorneys fees, tax advisor costs, an escrow fee, and brokers commission are also typically included.

How Long Does a 1031 Exchange Take?

A 1031 exchange may take as little as two days and many as 180 days. In a simultaneous 1031 exchange, two parties swap properties on the same day. However, the logistical challenge of identifying a second party willing to relinquish a like-kind property could make a simultaneous exchange difficult.

According to the IRS, the longest 1031 exchanges can take is?180 days. The 180 days begins when the investor sells their relinquished property. Within 45 days, they must identify potential replacement properties. The investor must purchase at least one of the properties by the 180-day deadline.

1031 Exchange Timelines and Rules

The rules surrounding 1031 exchanges can make the process tricky to complete. Before beginning the process, investors should understand the?timeline of a 1031 exchange and the specific rules that apply.

Identification Rules

1031 exchange investors must comply with one of the three?identification rules?when identifying potential replacement properties. These rules include the Three Property Identification Rule, the 200% of Fair Market Value Identification Rule, and the 95% Identification Exception.

• The Three Property Identification Rule:?This rule stipulates that investors can identify up to three potential replacement properties that they might wish to purchase.
• The 200% of Fair Market Value Identification Rule:?Investors using the 200% Rule may identify an unlimited number of like-kind properties to consider purchasing, provided their combined fair market value doesn’t exceed 200% of the total value of the relinquished property.
• The 95% Identification Exception:?This exception allows investors to identify more than three properties or more than 200% of the total value of the relinquished property as long as the properties they acquire are worth at least 95% of the value of the properties identified.

The 45-Day Rule

The first portion of a 1031 exchange timeline is the 45-day identification period. Replacement properties under consideration for acquisition in a 1031 exchange should be identified to the QI and must be identified no later than midnight of the?45th calendar day?following the close of the relinquished property sale transaction. Investors may use a?deadline calculator?to determine their 45-day period.

The 180-Day Rule

The concluding section of the 1031 exchange timeline is the 180-day closing period. Once the replacement properties are identified, the seller has a purchase window of up to 180 calendar days from the date of their original property sale to purchase a replacement property or properties. If the deadline passes before the sale is complete, the 1031 exchange is considered failed and the funds from the property sale are taxable. A?deadline calculator?can identify when an investor’s 180 days are up.

Reverse Exchange Rules

A?reverse 1031 exchange?is the opposite of a delayed exchange. In this type of 1031 exchange, the investor buys a replacement property and then sells a relinquished property. The investor must purchase the replacement property through an exchange intermediary to avoid owning both properties simultaneously. The taxpayer must declare the relinquished property within 45 days of purchasing the new property. At this point, they have 135 days to complete the exchange.

Partial 1031 Exchange Rules

A?partial 1031 exchange?allows investors to perform an exchange with like-kind properties and defer capital gains taxes while keeping some of the income from the swap. If an investor is willing to pay capital gains tax on a portion of the proceeds from the relinquished property sale, they may keep that portion and reinvest the remaining amount.

Benefits of a 1031 Exchange

Investors may be able to take advantage of several benefits if they complete the 1031 exchange process.

• Defer capital gains taxes:?One of the most significant benefits of a 1031 exchange is the ability to defer capital gains tax on the relinquished property. Investors can reinvest?the entire proceeds in other properties.
• Increase purchasing power:?Since a 1031 exchange allows taxpayers to defer capital gains taxes, which could?range from 15% to 20%, and depreciation recapture, those who complete the process can significantly increase their purchasing power for another property. Using a?capital gains tax calculator?can help investors understand how to minimize their tax burden.
• Diversify or consolidate portfolio:?A 1031 exchange can be a strategy for diversifying or consolidating a real estate investment portfolio. Investors who want to diversify their portfolios can complete a 1031 exchange to purchase several properties of different types. Taxpayers looking to consolidate their portfolios might use a 1031 exchange to sell multiple properties and buy one property.
• Erase deferred tax debt upon death:?An investor’s heirs are not responsible for any unpaid or deferred taxes that result from a 1031 exchange after the investor’s death. The heirs receive a stepped-up basis or readjustment of the value of the appreciated asset upon the investor’s death.

Drawbacks of a 1031 Exchange

The potential drawbacks are also important things to know before doing a 1031 exchange. Investors should understand a few disadvantages they might encounter or situations in which a 1031 exchange may not be their best option.

• Stringent rules and cost of failure:?1031 exchanges are significantly regulated, and failure to follow the requirements results in the disqualification of the 1031 exchange. Inadequately meeting the guidelines could result in a hefty capital gains tax.
• Illiquidity:?Investors who own properties used for 1031 exchanges must typically hold their properties to prove to the IRS that they are for productive use. This requirement makes 1031 exchange properties illiquid.

What Happens When You Sell a 1031 Exchange Property?

When a taxpayer sells a 1031 exchange property, several countdowns begin. The first is the 45-day limit for finding one or multiple like-kind replacements for the relinquished property. The second is the 180-day countdown to the closing day, during which time the taxpayer must purchase the replacement property, and the QI must transfer the funds into the investor’s account.

These rigid IRS rules put a strict timeline on investors looking to engage in a 1031 exchange. Because of the brief time investors have to complete the exchange process, it’s helpful to research and identify potential replacement properties before selling the relinquished property.

Investors may also consider how long they plan to hold a property before selling it utilizing a 1031 exchange. Many choose to hold a property for two years. The two-year holding period provides a couple of tax-filing years to prove to the IRS that the property is for productive use and isn’t intended for sale.

What Does the 1031 Exchange Process Look Like?

The 1031 exchange process is relatively straightforward, although some detours could occur that might alter an investor’s experience. Here is everything to know about a delayed 1031 exchange, the most common type of exchange, and what to expect from the process:

Select a QI

Selecting a reputable QI is the first step, as this party will prepare the 1031 exchange documents and ensure every stage of the process meets requirements. Investors may also work with other professionals, such as tax advisors or a 1031 exchange investment platform, to benefit from their experience and advice.

Prepare Exchange Documents

The QI may have the investor write a contract or purchase and sale agreement for the relinquished property in preparation for its sale. In addition, the QI will write exchange documents to convert the sale into a 1031 exchange.

Sell the Relinquished Property

Once the QI has prepared the 1031 exchange documents, the taxpayer can proceed with the sale of the relinquished property. The investor may have entered a contract with the buyer earlier, but they should beware that the 45-day rule applies as soon as they close.

Look for Replacement Properties

Investors must thoroughly research and identify the replacement properties they might wish to purchase. During this process, they must identify properties following one of the three?1031 exchange identification rules.

Follow 1031 Exchange Rules

During the 1031 exchange, taxpayers must follow the exchange rules, including purchasing replacement properties of equal or greater value than the relinquished property and obtaining like-kind properties. If they don’t consider these and other requirements during the exchange process, the exchange could fail.

Identify a Replacement Property

The investor must identify a replacement property or properties by midnight on the 45th day after closing on their relinquished property. A?1031 replacement calculator?can help investors determine how much property value they must acquire to qualify for a 1031 exchange.

Complete the Exchange

The taxpayer must complete the 1031 exchange within 180 days of selling the first property. To complete the exchange, the investor enters a contract with the seller of the replacement property and has the QI prepare the exchange documents for the transaction. The QI then sends the exchange funds to the seller to purchase the property and transfers ownership to the investor.

Have a Backup Plan: Alternatives to a 1031 Exchange

When committing to a 1031 exchange, many investors have a backup plan in case the exchange fails. Investors may encounter delays in selling a relinquished property or difficulty closing on a replacement property and need an alternative investment to avoid penalties. Having a backup investment option gives investors an alternative to choose when they want to benefit from real estate investment but want to protect themselves in case their 1031 exchange experiences difficulties. Delaware Statutory Trusts are a common alternative.

Delaware Statutory Trusts

A?Delaware Statutory Trust (DST)?is an entity that allows investors to own a proportional interest in the trust and receive distributions from rental income or property sales. One main advantage of DSTs is that you can identify a DST as one of your replacement properties by the end of the 45-day identification period for your 1031 exchange. The trust can serve as a backup if the properties cannot be closed on for any reason during the 180-day period.?

DSTs can be an effective?backup plan in a 1031 exchange.?Click here for more information?regarding the benefits and risks associated with DSTs.?

Investors must typically meet several suitability requirements before they can invest in a DST. For example, only accredited investors can invest in DSTs. According to the U.S. Securities and Exchange Commission, an?accredited investor?must meet one of the following requirements:

• Has an annual income for the last two years of over $200,000 individually or over $300,000 with a spouse or partner.
• Has an individual or joint net worth with their spouse or partner of over $1 million, excluding their primary residence.
• Is an investment professional in good standing holding a Series 7, Series 65, or Series 82 license.
• Is a “knowledgeable employee” of a private fund.

Partner With 1031 Crowdfunding

Although a 1031 exchange also offers potential risks, they are popular among real estate investors because of the potential for deferred capital gains tax and increased purchasing power. Following all 1031 exchange rules is critical for completing the process successfully, which is why investors can benefit from involving other professionals like a QI in the exchange.

At 1031 Crowdfunding, we offer a?marketplace for 1031 exchange properties?and other alternative investment vehicles, including DSTs. Our state-of-the-art marketplace provides vetted properties that are eligible for 1031 exchange. With a combined?$2.2 billion in real estate transactions?and?108 years in real estate investment, the management team at 1031 Crowdfunding has the experience to help you navigate 1031 exchanges.

Register to?create an investment account?with 1031 Crowdfunding.?You can also?visit our blog?to learn more about 1031 exchanges.

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