Setting up a 1031 exchange involves a series of well-defined steps to comply with the regulations set by the Internal Revenue Service (IRS). This post will dig into the details of several critical exchange components.
First, identify the investment property you wish to sell and simultaneously earmark the potential replacement property you intend to buy.
The property you are selling is called the relinquished asset. Typically, this is an investment property that has appreciated. As the investor, you may want to sell to leverage the proceeds into another property, change sectors, change your geographic footprint, or transition from active to passive involvement.
The replacement property (or properties) can be any “like-kind” asset, which means any property used for business or held for investment. The range includes options like housing, office space, hospitality and retail properties, raw land, mineral rights, industrial property, and self-storage facilities.
Using a Qualified Intermediary
Next, appoint a Qualified Intermediary (QI) to handle the transaction, ensuring they are competent and experienced. Determine the amount of the sale proceeds that will be invested in the new property, aiming to equal or exceed the sale price of the relinquished property for full tax deferment.
The QI is not only required by IRS rules but also their skill and diligence can determine the success or failure of the exchange attempt. The QI has three primary responsibilities:
- They hold the proceeds from the sale of the relinquished asset in a separate account throughout the exchange process, using the funds to complete the purchase of the replacement assets. This step is vital because the exchanger is prohibited from having access to the sale proceeds during the exchange process.
- Complete all applicable documentation for the exchange, particularly relating to the identification of potential replacement properties during the 45-day identification period.
- Facilitate the purchase of the replacement asset(s) using the proceeds from the relinquished property sale.
The IRS specifies that a QI can’t be the exchanger, a relative (except an in-law), a colleague, or an agent. However, the IRS does not specify any qualifications or credentials for the person charged with this essential responsibility. As the exchanger, it's up to you to choose a reliable and skilled QI to oversee your exchange.
Deadlines are vital.
Pay close attention to IRS-defined time limits: you have 45 days to officially identify the replacement property and 180 days to close the deal. While the IRS is generous with its definition of “like-kind” property in an exchange, it is strict regarding missed deadlines. The period allowed for execution is short, and investors must act quickly in order to succeed within the allotted time.
The short execution period is one reason many investors consider DSTs (Delaware Statutory Trusts) as replacement property options for their 1031 exchange. Finding an appropriate replacement property that matches the relinquished asset's value and debt load is a challenge. That obstacle makes the option of directing the proceeds into a DST attractive. Investors can customize the investment amount in a DST (as long as it is greater than the minimum). They can use this investment choice to transition from active to passive management, change real estate sectors, and more.
Separation of funds is a key component for success.
Finally, ensure all funds from the sale are handled by the QI until the purchase of the replacement property is finalized to stay compliant with 1031 exchange rules. The IRS will disallow the exchange if the investor has access to the proceeds between the sale of the relinquished asset and the consummation of the purchase of replacement assets, whether the replacement is direct property ownership or an equivalent investment in a DST.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
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.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
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.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
There is no guarantee that the investment objectives of any program will be achieved.
