A 1031 exchange can be a highly productive tactic for real estate investors, potentially enabling them to leverage the appreciation in one property to invest in others. Investors have varied motivations for selling an asset and replacing it with another one—including upgrading, diversification, geographic pursuits, and more. If the owner manages the transaction using a traditional sale and purchase arrangement, the investor will owe capital gains taxes on the appreciation of the property they sell. Paying that tax can restrict the amount they have available for reinvestment in a new property.
For example, suppose the investor sells an asset they have owned for several years, and the increase in value is $100,000. Depending on that investor’s income, the capital gains tax due could be as much as twenty percent, or $20,000. An investor would most likely prefer to have that $20,000 available for the next purchase. That outcome is possible if the investor structures the sale and replacement purchase using a 1031 exchange.
How does the exchange work?
For an investor to delay the payment of capital gains tax, they must plan ahead. The IRS has strict timelines attached to successfully executing a 1031 exchange. The clock starts ticking as soon as the initial property (typically referred to as the relinquished asset) is sold. In fact, savvy investors will usually begin searching for replacements before closing that sale because they have only 45 days to identify potential replacement properties formally. Those replacement options can consist of any of the following:
- The investor can identify up to three possible purchases of any individual or total value. Keep in mind that a 1031 exchange must replace at least the value and debt associated with the relinquished property. The investor will ultimately buy at least one of the three identified assets.
- The investor can identify more potential properties, but the total value can’t exceed 200 percent of the worth of the asset sold. Again, the investor will purchase at least one of the identified properties.
- The investor can identify an unlimited number of potential replacement properties but must buy 95 percent of the aggregate market value in the specified group (and, in each case, replace the value of the relinquished asset).
Who holds the funds during the exchange process?
One key aspect of successful 1031 exchanges is using a Qualified Intermediary—sometimes called an exchange accommodator. The Qualified Intermediary has several responsibilities, one of which is to hold and administer the funds during the sale and purchase process. The QI also receives the formal identification of the potential replacement options from the investor and oversees the transfer of funds to the seller when the selection is made. An investor must complete the transaction within 180 days of the initial sale, including the 45-day identification period.
A QI is usually either an individual financial professional or a specialized company with 1031 expertise. The person or firm should have expertise in transacting exchanges, supervising escrow, administering sales, and compiling tax forms. A QI can’t be the investor or related to them and can’t be an employee or agent of the investor. Investors should research the qualifications of QIs they are considering to ensure they engage an experienced party. The QI plays a crucial role in the transaction’s success.
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.
Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
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.
