Learn About 1031 Exchange

What Real Estate Investors need to Know

For real estate investors, taxes are just part of the deal. However, 1031 exchanges, which are named for the IRS Section 1031 of the IRS’s tax code, allow you to sidestep capital gains.
We’ve put together some tips about 1031 exchanges as well as some of the most important related rules you must follow.

What Is A 1031 Exchange?

A 1031 exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains or losses or capital gains tax that you otherwise would have to pay at the time of sale. This method is popular with investors looking to upgrade properties without being charged taxes for the proceeds.
You’ll also hear 1031 exchanges referred to as a like-kind exchange or a Starker exchange. Section 1031 applies to property beyond real estate, but many 1031 cases also deal with buildings and land.

How Does A 1031 Exchange Work?

As a seller, you can postpone capital gains taxes by selling a property and putting the proceeds toward a like-kind property, or property similar in nature and value.If you don’t receive any proceeds from the sale, there’s no income to tax. In other words, you gain no profit from the sale. That’s the idea behind a 1031 exchange, and here’s how to make that work.
Step 1: Identify The Property You Want To Buy And Sell
The initial step is to determine the property you want to sell and the property to exchange. The property you’re selling and the property you’re buying must be “like-kind,” which means they must be similar but not necessarily the same quality or grade.
Step 2: Choose A Qualified Intermediary
Then, you must work with a qualified intermediary, also known as an exchange facilitator, to handle a 1031 exchange transaction. The qualified intermediary holds your funds in escrow for you until the exchange is complete. You’ll want to carefully choose the right qualified intermediary, so you don’t lose money, miss key deadlines or end up paying taxes now instead of later.
Step 3: Tell The IRS About Your Transaction
Lastly, you’ll need to tell the IRS about your transaction through IRS Form 8824 with your tax return. On that form, you’ll describe the properties, provide a timeline, explain who was involved in the process and list the money involved.
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Relinquished Property
The relinquished property is being exchanged for another in a 1031 exchange. It’s also known as Phase 1 or Downleg.
Replacement Property
A replacement property refers to the like-kind parcel being bought with the proceeds from the relinquished property.

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What Is A Qualified Intermediary?

A qualified intermediary is a person or company that sells your property on your behalf, buys the replacement asset, and then transfers the deed to you. Let’s dig into a qualified intermediary’s job responsibilities a little further. They will:

Choosing The Right Qualified Intermediary

It’s important to choose the right qualified intermediary for you. Confirm that the qualified intermediary you’re considering offers:

Real estate experience

Does the qualified intermediary have extensive real estate experience?

Successful completion of compliance examinations:

Processors should meet annual compliance examinations, such as SSAE 16.

Transparency in transactions

Can you view your exchange money at all times? You want to know what’s happening with your money.

Fund security

Make sure your funds are held in an FDIC-insured account for safety.

When To Use A 1031 Exchange

There are multiple reasons why you might want to use a 1031 exchange. You may want to:

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1031 Exchange Rules And Requirements

Let’s discuss the rules and regulations that pertain to a 1031 exchange, including property requirements and time requirements.
Property Requirements
Finally, Section 1031 does not apply to these types of exchanges:
Property Requirements
You must also adhere to specific timelines with a 1031 tax exchange or the gain on the sale of your property may become taxable:

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Types Of 1031 Exchanges

You may want to look into three types of tax-deferred exchanges – delayed exchanges, reverse exchanges and build-to-suit exchanges. Consider the following:
Delayed Exchange
A delayed exchange is the most common exchange format because it offers you flexibility of up to a maximum of 180 days to purchase a replacement property. If the relinquished property is sold before you acquire the replacement property, the sale proceeds go to your qualified intermediary. The qualified intermediary holds the money until you acquire the replacement property and your qualified intermediary will deliver funds to the closing agent.
Reverse Exchange
A reverse exchange, or forward exchange, involves closing on the purchase of the replacement property before you close on the sale of the relinquished property. You may want to tap into this option to get a desirable replacement property when it’s a seller’s market, especially if you encounter competing offers or a pressing need to close quickly. When a replacement property is purchased before the sale of the relinquished property, again, the property must be transferred through an exchange accommodation titleholder – the qualified intermediary.
Built-To-Suit Exchange
A built-to-suit exchange, also known as a construction exchange or improvement exchange, is an exchange that allows the deferred tax dollars to be used towards renovations of the replacement property. The improvements must be completed within the 180-day period.

Tax Implications Of A 1031 Exchange

You may encounter some tax implications as a result of doing a 1031 exchange, including:
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