What is the purpose of a 1031 exchange?

A 1031 tax deferred exchange allows you to roll-over all of the proceeds received from the sale of an investment property into the purchase of one or more other like-kind investment properties. At closing, proceeds are transferred to a third party--called a facilitator or qualified intermediary--who holds them until they are used acquire the new property.

A 1031 exchange is often referred to as a Starker exchange.

Exchanges Allow You to Delay Capital Gains Taxes
Capital gains taxes are deferred if all of the exchange funds are used to purchase like-kind investment property.

The deferment is like getting an interest-free loan on the tax dollars you would have owed for a cash sale. More equity is retained, and that helps you move into properties of higher value each time you perform a 1031 exchange.

What's Eligible?
A 1031 exchange is possible when you sell real estate held for investment purposes.

 

It cannot be used for the sale of your personal residence. Like Kind Properties Exchanged properties must be like kind. For a real estate exchange this means real-property for real-property, but not necessarily land for land or a rental house for another rental house. Take a look at the IRS rules for specific information about what types of properties qualify as like kind.

You can exchange a single property for multiple properties, or purchase one property from the proceeds of several. Proceeds not used to purchase new investment property are taxed as a cash sale.

"In a like-kind exchange, both the property you give up and the property you receive must be held by you for investment or for productive use in your trade or business." -IRS

1031 Exchange Basics

Before you put the property under contract, find someone to act as a qualified intermediary, also called a facilitator or accommodator. This person or entity is a neutral party that takes possession of the proceeds from the sale of your property, uses the funds to purchase the new property, then transfers title of the property to you.

"A qualified intermediary is a person who enters into a written exchange agreement with you to acquire and transfer the property you give up and to acquire the replacement property and transfer it to you. This agreement must expressly limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary." -IRS

The Wording is Critical
Your contract to sell or purchase real estate must contain wording that shows an intent to perform a 1031 exchange.

 

A real estate attorney or your qualified intermediary can help you with the wording. You (or your agent) should send the intermediary a copy of the sales contract and any other information they require. Identifying the Replacement Property If you haven't already done so, identify replacement property. You have 45 days from closing on the relinquished real estate, the property you are selling, to identify up to three replacements. Your list must be sent to the intermediary in writing. The IRS offers no flexibility on this time period.

Closing Dates Are Important
The closing date for the new property must take place within 180 days of the closing on the relinquished property.

Keep In Touch with All Parties
You or your agent should stay in contact with the intermediary, keeping them advised regarding closing dates. They will be responsible for most of the paperwork associated with the exchange, and may have specific lead-time or other requirements for each step of the process.

Doing a Partial Exchange
If you plan to use only part of your proceeds for a 1031 exchange, consult with the intermediary to make sure your sales contract is worded correctly. You might also want to talk with an accountant to find out how the cash sale will impact your taxes.

Compare Intermediaries
Be sure to compare the services, costs, and references of several qualified intermediaries before selecting one to handle your 1031 exchange. The work they do is essential to the success of the exchange--make sure it's a trustworthy and experienced company or individual.

Ask as many questions as necessary to make you feel comfortable with the process. A tax deferred exchange is not difficult to do, but there are specific steps you must follow to make sure every aspect of the sale and purchase complies with US tax laws.

Janet Wickell is a co-owner and full time Broker/REALTOR at Brevard Realty Team in the Blue Ridge Mountains of Western North Carolina.

 

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