How To Do A 1031 Exchange: Its Benefits For Investors

You should be aware of the 1031 tax-deferred exchange if you own an investment property and are considering selling it and purchasing another. The capital gains tax can be postponed if the investor sells the property and immediately replaces it with another investment property of the same type. This article provides a high-level overview of the fundamentals of a 1031 exchange, including the concepts, types, and the process of getting started with a section 1031 transaction.

What Is a 1031 Exchange?

A 1031 exchange (also called a like-kind exchange or a Starker exchange) is a trade of one investment property for another that allows the deferral of capital gains taxes. Section 1031 of the Internal Revenue Code (IRC) is the source of this word, commonly used by real estate agents, title companies, investors, and even soccer moms. To avoid paying capital gains tax, investors can engage in a 1031 exchange, selling one investment property and buying another.

In essence, you can convert your investment to a different form without (in the eyes of the IRS) cashing out or realizing a capital gain. Therefore, your money can continue to grow tax-free. A 1031 exchange can be done as often as you choose. The profit from one investment property might be used to finance the purchase of additional properties. Although you could make money on each swap, you won’t have to pay taxes on that income until you sell it for cash. If all goes as planned, you’ll only have to pay tax once, and that tax will be at the lower long-term capital gains rate (now 15% or 20%, depending on income; and 0% for some lower-income taxpayers as of 2022).

Types of 1031 exchanges

There are four primary options for a like-kind exchange for real estate investors. They include simultaneous exchange, delayed exchange, reverse exchange, and construction or improvement exchange. If you want to avoid paying capital gains tax when buying a new home, any of these options are viable.

Simultaneous Exchange

Simply put, a simultaneous exchange is when one item of property is immediately traded for another. To use a cliche, this is the “first” 1031 transaction. Farmers and ranchers often trade goods and services, such as land and livestock. While simultaneous interactions might be quite straightforward, they can rapidly become intricate. A competent intermediary may still be necessary for complex simultaneous 1031 trades. Before initiating a simultaneous exchange, it’s a good idea to talk to a tax or real estate lawyer.

By completing the trade at the same time, both parties can avoid or postpone the occurrence of a taxable event. A simultaneous 1031 exchange, however, may pose some challenges. The simultaneous nature of exchanges can complicate logistics and make them difficult to execute. 

Complications can arise when the properties being swapped are located in separate locations. Despite the legality of interstate exchanges, it can be challenging to identify a property in another state, communicate with the seller, and close the deal due to the physical distance involved. The two properties must be located in the United States for Section 1031 to apply. Although other countries may have similar programs, it is not a 1031 exchange if you trade in domestic property for foreign property.

Delayed 1031 Exchange

The most popular method of exchanging property is through this form of 1031 exchange. The investor sells their current property and then buys a new one. The property to be given up must be transferred before the replacement asset can be acquired. The investor’s proceeds from the sale of the property are held in escrow by a third party until the transfer is completed. A 1031 exchange would be rendered null and void if the investor accepted the money since it would trigger a taxable event.

Your first steps toward initiating a delayed exchange should be marketing your property, locating a buyer, and finalizing the purchase agreement. The next step is to find a neutral third party to act as an exchange mediator and manage the sale of the property being given up. Before the 45-day period ends, you, the investor, must have acquired suitable replacement property. For as long as 180 days, the third party will hold the proceeds while you buy another property of the same type.

The benefit of a delayed exchange is that the investor has more time to finalize the deal. However, locating a new property within the 45-day exchange period can be a challenge. This 1031 exchange goes by several names, including deferred exchange, Starker exchange, standard exchange, or forward exchange.  

Reverse Exchange

In contrast to a delayed exchange, a 1031 exchange can be done in reverse. With a reverse exchange, you sell your current home before you acquire a new one.

The investor obtains the property through a third party known as an “exchange accommodation titleholder” in a reverse 1031 exchange. The investor can’t just buy the property without going through the middleman of the exchange. The agreement would fall apart if the investor also owned the target property. The 45-day window for reporting relinquished property begins whenever the taxpayer declares the intended sale property. The exchanging party has 135 days after that date to consummate the deal.

When there is concern that the perfect piece of real estate will be taken off the market, a reverse swap may be an alternative to acquiring the property swiftly. If you need to close on your replacement property before you can sell your current home, a reverse exchange may be a good alternative for you.

Construction or Improvement exchange

The earnings from the sale of the relinquished property can be used to fund the purchase of, and upgrades to, or repairs to, the replacement property as part of an improvement/improvement exchange. Thanks to the 1031 exchange for improvements, the amount of tax postponed is equal to the sum of the property’s purchase price and the renovations’ cost. The Exchange Accommodation Titleholder (EAT) must take legal possession of the replacement property while the Exchanger enhances it, as in a reverse exchange system. Within 45 days after closing, you’ll need to specify the replacement property and the upgrades you’d like to have made. On or before the 180th day, the exchanger must gain ownership of the property, and the stated improvements must be accomplished.

How to do a 1031 exchange

It is recommended that you seek the advice of a tax expert when navigating a 1031 exchange due to the complexity involved. The specifics of a 1031 exchange, including the regulations and specifications, can be found in IRS Publication 544.

Step 1: Determine the property you wish to buy and sell

The first order of business is to identify the two pieces of property involved in the exchange. The terms “like-kind” and “like-quality” refer to the similarity, but not necessarily the same quality or grade, of the properties involved in the transaction.

Step 2: Choose a qualified intermediary

The next step in completing a 1031 exchange is to hire a qualified intermediary, also called an exchange facilitator. The licensed intermediary will safely retain your assets until the trade is finalized. So that you don’t lose money, miss important deadlines, or pay taxes sooner rather than later, it’s crucial that you choose the correct certified intermediary.

Step 3: Decide how much of the sale proceeds will go toward the new property

All the money from the sale doesn’t have to be put into another property. If you reinvest your capital gains, you can delay paying taxes. If you decide to keep some money, you may have to pay a capital gains tax.

Step 4: Don’t lose track of time.

Generally, there are two dates by which you must act to avoid potential taxation of the gain from the sale of your property.

As a first step, you have 45 days from the date of sale to begin looking for a new home. The vendor or your certified intermediary must receive this in writing. Second, you can’t close on the new property more than 180 days after the sale of the previous one or the date your tax return is due (whichever is earlier).

Step 5: Be careful about where the money is

Keep in mind that the whole point of a 1031 exchange is to defer paying taxes on any sales proceeds. Therefore, if you take possession of the cash or other earnings before the exchange is complete, the contract may be voided, and your gain may be subject to immediate taxation.

Step 6: Inform the IRS about the transaction

Finally, you must include IRS Form 8824 with your tax return to notify the IRS of the transaction. Information about the properties, timeframe, participants, and financials will all need to be included on this form.

Are you ready to start investing?

Sum Up

Real estate investors can benefit from a 1031 exchange in many ways, including the ability to delay capital gains tax while expanding their portfolio and purchasing other investment properties. If you want to make sure that your 1031 exchange is carried out following the rules set forth by the Internal Revenue Service, it is recommended that you work with a skilled intermediary who can handle the transaction on your behalf and in the allotted time frame.