A 1031 exchange allows real estate investors to sell one property and roll those proceeds into a like-kind replacement asset. By doing this, investors can defer tax liabilities indefinitely so long as they keep reinvesting capital back into real property.
Buyers in a 1031 exchange need to be aware of each step of the transaction, including the strict timeline and anything that could go awry. If everything doesn’t go according to plan, you could be hit with capital gains and other taxes, which can take a large chunk out of your proceeds.
Identifying a Replacement Property in a 1031 Exchange
In a classic exchange, one property is swapped for another between two people. However, this rarely occurs. There’s a slim chance someone has a property that you want and you have a property that they want. Because of this reason, most exchanges are delayed, three-party, or Starker exchanges.
When a buyer is executing a 1031 exchange, they will typically need the services of a Qualified Intermediary (QI). During the transaction, the QI will:
- Hold the proceeds from the sale of the relinquished property in escrow. The buyer cannot take possession of these funds throughout the exchange process.
- Complete all documentation within the mandatory 45-day identification period.
- Transfer the exchanger's funds to the title company/seller.
Within 45 days of the sale of the property, the buyer must identify up to three replacement properties from the date of the closing on the relinquished property and then close within 45 days of identifying replacement properties. More than three properties can be identified if the collective value doesn’t exceed 200% of the relinquished asset’s sale price.
If any of the above dates are missed, the transaction will be seen as a sale instead of a 1031 exchange. Therefore, the taxpayer cannot defer the recognition of gain on the original sale. The buyer will need to secure financing or capital equity to complete the transaction on time. This must be done before the end of the 180 day exchange period.
Close on the 1031 Exchange Replacement Property
Once the deal is closed, the QI wires funds to the title company. If any funds are left over after the QI acquires the replacement property, also known as boot, the QI will pay it out at the end of the 180 day exchange period. Boot is taxed as partial sales proceeds from the sale of the property.
Important Things to Consider in a 1031 Exchange
When you enter into a 1031 agreement, you have the potential to defer your capital gains tax liability if you put proceeds from the sale directly into another like-kind property. Keep in mind that this doesn’t mean capital gains are eliminated; they are only postponed.
Selecting the right QI is also essential in the success of your 1031 exchange. As a buyer, your QI will hold your funds from the sale of your relinquished property in an FDIC-insured bank account. Your QI will also understand how to facilitate the purchase of a replacement property and complete a wire transfer to the title company. Do your due diligence before selecting your QI.
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.