Successful execution of a 1031 exchange requires planning. The purpose of the exchange is to defer the obligation to pay capital gains taxes on the sale of a real estate investment. The deferral process requires that the proceeds from the sale of the asset be exchanged into a like-kind property of equal or higher value.
Suppose that Joe the taxpayer owns a rental property he purchased several years ago. Joe's adjusted basis in the rental is $400,000, but he wants to buy a newly constructed retail property. Joe’s rental has a current market value of $750,000, which would require him to pay capital gains tax on the difference between the $400,000 basis and the present value of $750,000, or $350,000. That's a substantial levy, and if Joe would prefer to reinvest the funds into the retail property, he can pursue the 1031 exchange strategy.
A Successful Exchange Has Strict rules and Timelines
Continuing with the example of Joe, if he waits until he has sold the rental property to decide that he wants to employ the 1031 exchange process, his effort will be unsuccessful, and the exchange will fail. The primary reason is that in an exchange, the investor mustn't take possession of the proceeds from the original property sale (often called the relinquished asset). If the investor has access to the funds between the sale and the later purchase, the IRS won’t allow the deferral.
Instead, the funds from the sale are handled by a Qualified Intermediary who is responsible for administering the transaction. The Qualified Intermediary is often referred to as an exchange accommodator and is a critical participant in a successful 1031 exchange. That individual is charged with these tasks:
- Creating and overseeing a separate account to contain the proceeds from the sale and using those funds to consummate the purchase of the replacement property. As mentioned, the investor must not have access to the account.
- Receive from the exchanger the identification of potential replacement properties within the required timeline and maintain documentation of the submissions.
- Facilitate the purchase of the replacement asset(s) and maintain meticulous records of the entire transaction.
Can the Investor Start the Process After Closing?
Perhaps Joe the investor decides to sell his rental property without fully considering the ramifications of the transaction. Once he reaches the closing stage, he realizes that he will have quite a hefty tax obligation, reducing the amount that he has available for his next investment. While the 1031 exchange rules prohibit the investor from receiving the funds, there is one approach he can try. In some cases, sellers have been able to rescind the sale (only with the agreement and cooperation of the buyer) and start over with the assistance of a Qualified Intermediary. Although the IRS has not formally approved this avenue, there are some examples of successful completion.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Hypothetical examples are for illustrative purposes only.
