The 1031 Exchange Process

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1031 Exchange Timelines & Guidelines

You have 45 days to identify a new property after the sale of an existing one. You have 180 days to purchase the identified property with the funds received from the sale of the old property.
The 1031 Exchange begins on the earliest of the following:
A. The date the deed records.
B. The date possession is transferred to the buyer.

The 1031 Exchange ends on the earlier of the following:
A. 180 days after it begins.
B. The date the exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.

1. Identification Period & Total Exchange Period
The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason, except for a presidentially declared disaster.

2. Title Rule
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you are married and sell the old property, then your spouse must also be on the title to the new property. If a trust or corporation is on the title of the old property, that same trust or corporation must be on the title of the new property.

3. Intermediary Requirement
This is one of the easiest requirements to fulfill.  It is also one of the rules that is broken most often. Sellers cannot have access to the money in between the sale of the old property and the purchase of the new property. The IRS states that an independent third party, known as a qualified intermediary, must be used. The qualified intermediary must not be related to you in any way. There are strict documentation rules intermediaries must follow to comply with all the IRS guidelines. The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds, but must treat the interest as ordinary income during the period of escrow.

4. Reverse Exchange
This is an extremely confusing legal issue, but it boils down to this:
You can't own both properties (the one you are selling and the one you are buying) at the same time. This section of a 1031 transaction comes in handy when you have a property under contract to buy, but you have not yet sold your existing property. There can be a major financing problem with this, whereby this exchange requirement comes into effect.

The IRS will let you put the property you are purchasing in an exchange entity (typically an LLC). The old property must be sold and closed within 180 days of first acquiring title to the new property. As soon as the old property is sold, the proceeds are then directed to the exchange accommodation titleholder at which time the property may be deeded out of the holding arrangement directly to the taxpayer.

5. Reinvestment Requirements
You don’t have to reinvest 100% of the proceeds into another property. You can do a partial exchange. However, you must recognize the income if there is a capital gain.
You can also designate multiple properties as replacement properties. However, the fair market value of the replacement properties cannot exceed 200% of all the exchanged properties. The IRS performs certain valuation tests for this.

6. Like-Kind Property
The like-kind requirement states that the property being sold and the property being bought should be like-kind. This is frequently misunderstood. The purpose of this rule is to discourage professional flippers from taking advantage of the 1031 exchange to avoid capital gains tax.
The factor that seems to weigh the most is the intent of use for the property. One of the basic premises is that your primary residence can never be used for a 1031 exchange. 

Alternatives to 1031 Exchanges
A negative with 1031 exchanges is the time requirements to purchase a property. This can lead to a less than perfect deal. However, there is are alternatives to a 1031 exchange, and you can still defer the taxes. Two of these alternatives are a Structured Sale and the less known Deferred Sales Trust. Structured Sales and Deferred Sales Trusts work well for sellers who want to create a continuing stream of income without management worries. Retiring business owners and downsizing homeowners are examples of sellers who can benefit. See further explanation of these alternative methods in the index at the top left of this page.

Common mistakes seen most often with 1031 Exchanges:
1. Not starting the search for their replacement property until they complete the sale of their relinquished property. While the closing of the sale must happen prior to the closing of the purchase, there is no similar requirement regarding going into contract. So the best course is to locate and get your new property under contract prior to the sale or immediately after - rather than waiting and trying to search for a good replacement property during the 45 day identification period.

2. Like-kind means that any kind of investment real estate may be exchanged under 1031 for any other kind of investment real estate. Residential to commercial, industrial to raw land, single family to multifamily. It is all considered like-kind. And the number of properties does not matter. So it is possible to sell one and buy two or sell two and buy one.

3. People think that they need only reinvest the profits from their old property, and that they can take their original capital back without paying tax. While it is true that your original capital or down payment will not be taxable, the IRS says that if you are doing a 1031 exchange and you do not purchase at least as much as you sell, using all of the proceeds in the next purchase, then the amount that you buy down or the cash you take out will be your profit first, and you will not take out your original capital until the last. So while a dollar is a dollar, and you can argue that you are taking out nontaxable original capital, the IRS says you are taking out profit. 

4. Not seeking the advice of their legal, tax, and financial advisors – and a good qualified intermediary – before structuring the 1031 exchange transaction. The challenge is that investors don't know what they don't know, and may not know when they have a potential problem with their 1031 exchange transaction. Potential problems can almost always be fixed if caught before the investor closes on any of their transactions, but usually become permanent once a transaction closes. Consulting with their legal, tax, and financial advisors can save people thousands of dollars in income taxes.

5. Recognizing the need for a formal 1031 exchange agreement and exchange partner to hold the funds. They receive funds at closing, mistakenly believing they can still do an exchange. Once funds are disbursed, they can never touch the hands of the seller. Funds must always be held by the intermediary and used to purchase the replacement property - outside the control of the seller.

Hopefully you now have a better understanding of what a 1031 exchange is and how it can benefit you and your real estate investing. However, it’s recommended that you consult with your tax accountant and an attorney who has experience with 1031 exchanges.