1031 Exchange - Equity Reinvestment and Market Adaptation
The information provided here is not investment, tax or financial advice. Consult with a licensed professional for advice concerning your specific situation.
Real estate has many advantages over other investments and one of them is Section 1031 of the Internal Revenue Code. A 1031 Exchange enables you to defer capital gain and depreciation recapture taxes on the sale and replacement of a qualifying property. The basic process is illustrated below.
The sequence of events are as follows:
- Sell the investment property
- Escrow receives funds from the buyer and wires them to a Qualified Intermediary of your choosing. Note that you do not touch the money.
- Locate the replacement property and close.
- The funds are wired from the Qualified Intermediary to the escrow company.
There are timelines that you cannot exceed, which are illustrated below. My understanding is that if you exceed the 45 day identification period or the 180 day close period, you could lose the tax deferment.
The Seven Rules of a 1031 Exchange
Below are the 7 rules to be aware of with a 1031 exchange.
- Only Business or Investment - The 1031 exchange cannot be used for non income producing properties. Two examples of what does not qualify for 1031 exchange: residence to residence and residence to rental property. It must be income producing property to income producing property.
- Only for Like-Kind Properties - Both the relinquished and replacement property must be real property, not stocks, CDs, etc. You can exchange multiple properties for one or one property for many.
- Equal or Greater Value - The replacement property or properties must be equal or greater than the relinquished property if you wish to defer 100% of the tax.
- Identification Window - You must identify a property within 45 days of the date of sale of the relinquished property.
- Purchase Window - The purchase of the replacement property must be completed within 180 days of the sale of the current property. OR the due date of the income tax return for the tax year in which the relinquished property was sold - whichever is sooner. However, you can file for an extension so that you get the full 180 days.
- Qualified Intermediary - You can not handle the 1031 yourself. You must work through a Qualified Intermediary. If you need a referral, let us know. Note the cost for the Qualified Intermediary's services typically range from between $800 to $1,300. If there are multiple properties involved in the exchange there is an additional fee per property.
- Title Name - The name of the person/entity selling the relinquishing property must be the same as the person/entity buying the replacement property.
We've done many 1031 exchanges. We are always concerned that a client could identify a property at the end of the 45 day identification period. Then, during the closing process, the property falls out of escrow for some reason. If this occurred , I believe you would lose your tax deferment. What we attempt to do is to not only identify the replacement property but also close it in the 45 day identification period. If we work on this timeline and the property does fall out, we have time to identify another property. We've never had to do this but it would give us a second chance. See the diagram below.
It looks a bit complicated so I will walk through the steps.
- When the client has decided to exchange a property for another, we have a good guess as to how long it will take for the property to go under contract and sell. Once we have a contract on the relinquished property and are past any financing contingency, we will place the replacement property under contract.
- We close on the relinquished property and the funds are sent directly to the 1031 Exchange Agent.
- We close on the replacement property as soon as possible after the relinquished property closes.
The above process works very well.
Real estate has many unique advantages, the 1031 Exchange is just one advantage. And, as long as you work with agents who are experienced with doing 1031 Exchanges, there is little additional required work on the part of the owner.