How is a 1031 Exchange Done?

There are many different costs involved in selling property. One of the largest costs that you can expect to incur is a tax liability known as capital gains tax. This is a tax that is levied on profit made from the sale of a property or an investment. Exactly how much tax you will be expected to pay will depend on your individual circumstances, but you may be liable to pay as much as 20% of the profit from the sale of your home back to the IRS.

Fortunately, there is an alternative that gives you the opportunity to defer your capital gains tax – potentially indefinitely. It is known as a 1031 exchange.
 

What is a 1031 exchange?

A 1031 exchange is named so because it refers to Section 1031 of the U.S. Internal Revenue Code. This rule enables you to defer paying the capital gains tax due on your property sale, provided you meet certain criteria. Better still, there is no limit on the number of times that you can do this in your lifetime and you can roll over the gain from each sale over and over again, so long as you meet the requirements to qualify for a 1031 exchange.

In deferring the tax due on the sale of your property, you can actually reinvest the value into your next purchase – much like receiving an interest-free loan from the government. These extra funds may make all the difference when it comes to securing the next best investment.
 

What are the rules for a 1031 exchange?

As you would expect, there are numerous rules and criteria surrounding the use of a 1031 exchange and that you must meet in order to qualify for one. Some of the most basic rules are as follows.

A 1031 exchange isn’t for personal use

The provision is only for investment and business property, meaning that you cannot swap your primary residence for another home.

The exchange must be ‘like-kind’

Contrary to popular belief, this doesn’t mean that you have to exchange land for land, or a commercial building for another commercial building. There is a great deal more flexibility, something which your exchange facilitator can help you with.

The property must have been held by you for a while

There is no definitive ruling on exactly how long you should have owned a property before selling it through a 1031 exchange. However, the general expectation is that there is a minimum holding period of 12 months.

You must use a qualified intermediary

Also known as an exchange facilitator, this person represents an unrelated third party who enters into an agreement to acquire and transfer the properties involved in the transaction, on behalf of the parties involved. Although there are no federal regulations for 1031 exchange facilitators, and only two states have licensing and bonding requirements, we strongly recommend that you use a full-time facilitator with plenty of experience.
 

How is a 1031 exchange done?

Most people assume that anything tax-related is going to be a lengthy and complicated process. While there are certain rules that you will have to adhere to, with the help of a professional you will probably find that a 1031 exchange is much simpler than you expect.

Here is a short, step-by-step guide to how a 1031 exchange is done.

Choose your qualified intermediary

This will be the person who handles the exchange on your behalf. Choosing a professional with plenty of experience and a great reputation is crucial as they will handle the funds on your behalf. Your exchange facilitator should be up-to-date on the current legislation and help the entire process run much more smoothly. Most people choose a bank or law firm.

Find a buyer

Sometimes easier said than done, but once you have found a party willing to purchase the property you wish to relinquish, and you have accepted their offer, you will enter into a Purchase & Sale Agreement with them.

Insert the 1031 clause into the Purchase & Sale Agreement

If you have hired the services of an attorney to draft the agreement, they will be able to do this on your behalf. The clause should make it clear that you intend to use the transaction to complete a 1031 exchange, and your buyer accepts this information. When the buyer then signs the agreement, they are also legally accepting these terms.

Enter into an exchange agreement with your qualified intermediary

This is an agreement than enables your intermediary to receive the funds from the sale of your relinquished property, hold them, and then use them to purchase your like-for-like replacement on your behalf. You must do this before the closing date for the sale of the property you are selling.

Identify the property you wish to exchange your relinquished one for

This is usually referred to as the replacement property, and you must identify this in writing, sign the document and pass it to your qualified intermediary within a 45-day timeframe.

Arrange for your exchange facilitator to enter into a Purchase & Sale Agreement with the seller of your replacement property

Your intermediary will then use the fund from the sale of your relinquished property to complete the replacement property purchase. This must be done within 180 days of the sale of your relinquished property, or the date which the income-tax return for the year of sale is due.

File IRS form 8824

This must be done for you to receive the tax-deferment benefit of the exchange and should be done in the tax year during which the exchange occurred.

Report the 1031 exchange as per your state reporting requirements

Since it is a product of federal law, you must comply with any reporting requirements that your state has. Your tax attorney will be able to help you with this.

If you would like further information about a 1031 exchange, our experienced and professional team are here to help. Please don’t hesitate to get in touch and contact us today.