How Investors Use a 1031 Exchange

One of the primary ways that homeowners amass wealth through real estate is through appreciation, and the ability to buy homes with as little as 3% down. And thanks to certain, easily attainable requirements, homeowners can keep the proceeds from the sale of those appreciating homes, tax free. Investors on the other hand, do not benefit from exemptions that protect those capital gains. But thanks to IRC 1031, a properly structured 1031 exchange allows an investor to sell an investment property, and acquire a new property, and potentially defer all capital gains taxes. IRC 1031(a)(1) states:

No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.

The Power of Flexibility

Regulations around IRC 1031 state that capital gain deferment requires the exchange of like-kind relinquished property for other like-kind replacement property. In general, that means real property held for investment or used in a trade or business can be exchanged for other real property held for investment or used in a trade or business.

To fully defer all capital gain taxes, an exchanger (that’s you) must meet two requirements:

Reinvest all exchange proceeds to acquire like-kind property.
Acquire like-kind property of equal or great value.

What’s the First Step?

First and foremost, always discuss the 1031 tax-deferred exchange with your tax and/or legal advisors prior to starting your transactions. Next, call a Qualified Intermediary for a consultation BEFORE closing on a relinquished property. And finally, include language stating your intent to perform a 1031 tax deferred exchange in the purchase and sale agreement:

“Buyer is aware that Seller intends to perform an IRC 1031 tax-deferred exchange. Seller requests Buyer’s cooperation in such an exchange and agrees to hold Buyer harmless from any and all claims, liabilities, costs or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to <qualified intermediary>, by the Seller.”

The Delayed Exchange

While there are several different kinds of exchanges, the most common format is the Delayed Exchange, and the one we’ll be discussing here. It provides investors up to 180 days to acquire replacement property through the use of a Qualified Intermediary to complete a valid delayed exchange. A Delayed Exchange is performed in three steps:

Sale of the Relinquished Property

Prior to closing on the sale of the relinquished property, the Exchanger enters into an exchange agreement with a Qualified Intermediary. Pursuant to that agreement, an assignment is executed prior to closing where the Exchanger assigns its rights under the purchase and sale agreement to the Qualified Intermediary.

The Qualified Intermediary then instructs the escrow officer or closing attorney to directly deed the property from the Exchanger to the Buyer. Proceeds are then transferred directly to the Qualified Intermediary, thereby protecting the Exchanger from actual or constructive receipt of funds.

1031 regulations mandate restrictions on the Exchanger’s ability to access proceeds from the sale at any time. Please consult with your Qualified Intermediary for more details on these restrictions.

Identification of Replacement Property

The Exchanger must properly identify potential replacement properties within 45 calendar days of the closing of the relinquished property. The Qualified Intermediary will provide the Exchanger with the specific identification requirements prior to the closing of the relinquished property.

Purchase of the Replacement Property

The Exchanger has a total of 180 calendar days from closing of the relinquished property, or their tax filing date (including extensions), whichever is earlier, to acquire like-kind replacement properties. The 45 day identification period is included in this 180 day period, not in addition to it.

Prior to closing on the replacement property, the Exchanger assigns the Purchase and Sale Agreement to the Qualified Intermediary. After the assignment is executed, the exchange is completed when the Qualified Intermediary purchases the replacement property with the exchange proceeds and transfers it back to the Exchanger by a direct deed from the Seller.

Avoiding Pitfalls

A 1031 Exchange is not only a real estate transaction, it’s also a tax transaction. Make sure you setup the exchange properly and use a reputable qualified intermediary. Most real estate attorneys and title companies are familiar these types of transactions and can provide advice, and even some recommendations for qualified intermediaries, but always always always check with your tax advisor before beginning any such transaction.

Another common pitfall is not watching your timeline. Your 45 day identification period and 180 day closing period are not suggestions. The IRS adheres strictly to their rules, and it is VERY difficult to get extensions. Do not plan on one and don’t think of one as your contingency plan.

One very important rule to keep in mind… if you receive cash, you pay taxes. So plan accordingly. If your relinquished property is sold for $500,000 and your replacement property is purchase for $400,000 and the title company subsequently gives you a check for the difference, you’ll pay capital gains taxes on that $100,000.

You can apply the proceeds of one investment property to purchase multiple replacement properties, but be prepared to bring additional funds if your initial closing isn’t enough for the purchase.