WHAT IS A 1031 EXCHANGE?
William “Bill” Exeter, CEO & President of Exeter 1031 Exchange Services, has been specializing in real estate tax strategies since 1985 with an extensive knowledge of 1031 and 1033 Exchanges. Bill has written, lectured, taught and trained investors extensively on 1031 and 1033 Exchange transactions, Tenant-In-Common (TIC) investment properties and Delaware Statutory Trusts (DSTs).
With his expert knowledge, Bill walks us through the process of how to conduct a 1031 exchange with real estate investment properties, and breaks down the timeline, identification process, closings and more. *None of the information contained in this article is legal or accounting advice. Before making any decisions regarding your property or situation, you should consult your own professional service providers.
Executive Summary
No real estate investor is thrilled with the idea of having to pay taxes on their properties. However, conducting a 1031 Exchange can allow you to avoid paying capital gains taxes.
If you want a savvy tax saving strategy for your real estate assets, continue reading to learn:
What Is a 1031 Exchange?
Named after the IRS Code Section 1031, a 1031 Exchange is swapping one real estate investment property for another investment property (a “like-kind” exchange).
This real estate investing technique allows you to defer (or hold off) paying capital gains taxes that would typically be due at the time of sale.
How to Do a 1031 Exchange
There are two different ways you can conduct a 1031 Exchange: invest your money from the like-kind exchange of properties using a Qualified Intermediary and investment real estate sales firm; or invest in a group that invests your money on your behalf. For the sake of understanding all of the components that go into a 1031 Exchange, let’s focus on conducting a like-kind exchange.
Let’s say you have a property that is not performing as well as you hoped, so you look to sell. As the seller, you decide to sell your current property and put the money toward a similar type of property with similar value. As long as you do not receive any profits from the like-kind exchange, you do not have to pay any income tax and you defer capital gains tax, or state and federal taxes of the property.
This is why a 1031 exchange is seen as tax-efficient for real estate investors; if you find a like-kind property that looks to perform better than your current property in the future, you get to upgrade your real estate investment and postpone paying capital gains tax.
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Steps of Conducting a 1031 Exchange
With a 1031 Exchange, it is all about planning. Here is how it works:
1. Hire a reputable commercial investment real estate brokerage firm.
You will want to meet with a knowledgeable advisor to assess your options and finances to make sure a 1031 Exchanges is the best course of action. Don’t ask yes or no questions; ask open-ended questions and you will quickly figure out those who really know what they’re talking about and those who don’t.
2. Hire a Qualified Intermediary (QI).
A Qualified Intermediary has to draft all the 1031 exchange documents that have to be executed before the closing occurs. The purchase and sale agreement for the sale of your property is assigned to the QI and that is what prevents any tax consequences.
If the property closing occurs, it does not matter what you tell the closing agent. Even if you say don’t disperse the money yet to the buyer of your property, the buyer has the right to the funds and you will have to pay the capital gains tax. The like-kind exchange has to be set before closing, otherwise it is taxable and there is no way to go back.
Most QIs will provide them with some type of identification form, like an IRS Form 8824, that identifies the property you would like to buy for the like-kind exchange. On the identification form, you will describe the properties you would like to buy, your timeline for the sale, who is involved in the process, and any financial parties involved.
You can find a Qualified Intermediary by talking with an investment firm (Step 2), a real estate attorney or a CPA with 1031 exchange experience.
3. Find a lender for your transaction.
To ensure you can meet the timeline and qualifications of the 1031 Exchange, you will want to have your financing sorted out before any purchase or sale occurs.
4. Identify the Property you want to sell.
Determine the property you would like to sell to conduct the exchange and know the value of the property to ensure you choose a property similar in value to swap. Once choosing your property to sell, provide all paperwork to the investment broker, Qualified Intermediary and attorney that will handle the sale.
5. Identify the property you want to purchase within 45 days of the original sale.
Once the transaction closes on the sale of your property, there is no way to go back and restructure it as a 1031 exchange. Once you sell, you have 45 days to pick properties you want to identify for the like-kind exchange.
Most people use the Three Property Rule, meaning you identify up to three properties to your Qualified Intermediary (usually with the idea of identifying three and buying only one). You typically want to identify more than one property to ensure you have a backup property to purchase in case your first choice falls through or does not meet the requirements of the exchange.
6. Close on the property you are selling within 180 days.
A lot of people think it is 45 days to choose a property to buy and 180 days to close on your property. However, you actually have 45 days plus an additional 135 days to fully complete your purchases and close on your sale, for a total of 180 days.
After the 45-day period to choose your like-kind exchange, you will let your Qualified Intermediary know what property you have decided to pursue.
Once you have taken care of the steps you need to complete, your investment real estate broker firm and QI will take care of the rest with the escrow company, title company, closing attorney, etc.
Why Choose a 1031 Exchange
If you conduct a 1031 exchange with a property that is equal or greater than what you sold, you’ve traded equal or up in value. You have reinvested all of your equity and deferred all of your federal and state taxes.
Real estate investors typically seek out 1031 exchanges when they have properties that are not performing to their liking and they know that they can find properties that are similar types worth similar value that will produce more cash flow in the future.
1031 exchanges upscale your investment portfolio, aim to increase cash flow, and create tax-saving real estate deals for long-term wealth preservation and wealth creation.
The best strategy for these like-kind exchanges: Defer, Defer, Defer.
If you continue to do 1031 exchanges over your lifetime, you get a step up in cost basis when you pass. Under the current tax law, whoever you leave the 1031 property to — your kids, grandkids, friends, etc. — they get a step up in cost basis. This means their cost basis for the property is stepped up, or increased, to the fair market value at the date of passing and they pay zero taxes.
Though with a morbid sense of humor, you can “Swap until you drop.”
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*Note: Note: Invest On Main LLC (collectively investonmain.com) have made every attempt to ensure the accuracy and reliability of the information provided. Invest On Main cannot not accept any responsibility or liability for the accuracy, content, completeness, legality, or reliability of the information contained herein. The information herein is not considered legally binding legal advice, tax guidance, or financial counsel.
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About the author
Michael Flight
Michael Flight was named the Godfather of Blockchain Real Estate by Forbes Crypto. Michael achieved that distinction by co-founding Liberty Real Estate Fund, the World’s First Net Lease Security Token Fund, creating the Blockchain Real Estate Summit. More recently co-founding Invest On Main (IOM.ai) the Real Estate & Alternative Asset marketplace of the future and AcceleratedLaw a faster, cheaper way to create and tokenize securities offerings!
Michael is a real estate entrepreneur and real estate tokenization pioneer who is an expert in retail real estate investment, redevelopment and real estate on the blockchain. He started his commercial real estate career in 1985, and then co-founded Concordia Realty Corporation in 1990, which continues to partner with some of the world’s most well-known banks, insurance companies, hedge funds and institutional investors in many successful investments.
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