1031 - Replacing Under-Performing Properties
If you have an under performing property, maybe its time to replace it with a better property. We have handled many 1031 Exchanges for our clients. This article outlines the process. Note that we are not attorneys, accountants nor 1031 Exchange agents.
The information provided here is not investment, tax or financial advice. You should 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. 1031 exchange enables you to defer capital gain and depreciation recapture taxes on the sale of the qualifying property. The exchange process is relatively simple since you must use a Qualifying Intermediary. Below is a diagram showing how the funds from the sale of the current under-performing property are used to purchase the replacement property.
All proceeds from the sale of your current property (the relinquished property) flow from the escrow company directly to a Qualified Intermediary who holds the funds until you close on the replacement property. There are time line that must be met. See the graphic below.
The seven rules of a 1031 exchange.
- Only Business or Investment - The 1031 exchange cannot be used for non income producing properties.
- Only for Like-Kind Properties - Both the relinquished and replacement property must be real property. 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. While all you are required to do is to identify the property within the 45 day window, we do our best to identify and close within the 45 day period. We do this because we do not want to expose our clients to the risk of having the identified property fall out and losing the tax deferred exchange. We encourage our clients to start identifying and placing replacement property under contract a few days before the close of the relinquishing property. This way if something happens, we have time to find another property. Also, it is best if we work directly with the agent selling your existing property. Not many agents have experience with 1031's and specific verbiage must be included in the sales contract.
- 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.
- While the above may sound complex, it is relatively easy if you work with agents who have experience with 1031 Exchanges like us. We can direct you to the right resources.
- If you purchased property through your IRA, you can still perform a 1031 Exchange.
- An 1031 Exchange only makes sense if you have significant gain on the current property. If the gain is minor or a loss, a 1031 does not make sense.
There is little advantage to hanging onto under performing properties. A 1031 Exchange may be the right solution for you. Don't we all wish that we could exchange poorly performing stocks into high performing ones with no tax impact!