Once upon a time the phrase “1031 exchange” was rarely heard among investors. However, the ability to defer capital gains taxes almost indefinitely has made 1031’s a household world, to the extent that some investors are even using it as a verb i.e. – “we’ll 1031 that property.”
There’s no doubt that 1031 exchanges are an incredible asset for investors, but if you still haven’t got a clue how they work, then this guide is exactly what you need. Not only will you learn what 1031 exchanges are, but it will also walk you through the steps towards completing a 1031 exchange successfully.
What Is A 1031 Exchange?
A 1031 exchange allows you to defer capital taxes on a newly-acquired property. It works by exchanging one property – one you already own – with a new “replacement property.”
Properties used in the exchange must be used for investment, not personal use, and the replacement property must be similar in nature to the original property.
This is termed “like-kind,” but don’t worry, the laws of what qualifies as like-kind are actually quite liberal. For example, you can exchange land for an office building, or a multifamily apartment building for a quick service restaurant. Plus, you can purchase more than one replacement property, as long as the combined purchase price of the properties is equal to or more than the sale price of the original property.
You have 45 days to identify a replacement property, and 180 days to complete the transaction – no exceptions. If you choose a replacement property by the 45th day, then you have 135 days to close the deal. The cost of the replacement property must the same or more than the original property; if it is less than the original property than the remaining sum of money, termed “boot,” will be subject to taxes.
Here are the steps to successfully completing a 1031 exchange:
1. Find a Qualified Intermediary
According to the IRS, you the investor are not allowed to execute a 1031 exchange on your own. Instead, it must be accomplished through an intermediary.
Once you sign an agreement with the intermediary, your right to receive any form of benefit from the property or money held by the intermediary is limited.
The intermediary will act in your stead to sell the original property, purchase the replacement property, plus execute all required transactions and contracts necessary to qualify for a 1031 exchange.
The qualified intermediary doesn’t actually hold the title to the property; once they acquire the original property from the buyer, they transfer it back to the buyer, acquire the replacement property, and then transfer it back to the investor.
So for all intents and purposes, the qualified intermediary acts as your agent.
1031 exchanges can be complicated yet technically, and with the exception of Nevada, California, Idaho, Colorado, and Arizona, there are no federal or state requirements that govern intermediaries.
Since a failed or mishandled exchange can cost you hundreds of thousands of dollars in “lost” money, it is essential to do your due diligence to find an experienced qualified intermediary.
Whether your intermediary is sufficiently qualified depends on whether or not they have had training in 1031 exchanges and have successfully completed numerous 1031 exchanges with the property types you own or plan to own.
Usually, they are brokers, attorneys, bank affiliates, tax accountants, or title company affiliates, although they may not have any training or experience in tax-related issues related to the exchange.
Intermediaries can voluntarily complete certification for becoming 1031 Exchange specialist, as well as become a member of the FEA, or Federation of Exchange Accomodators. In addition, you can check the reputation of a potential qualified intermediary online, as well as ask for references.
Any qualified intermediary should be willing to meet with you before you agree to sign with them, in order to discuss your investment needs and determine the best plan for concluding the exchange successfully.
Make sure to also ask the intermediary if they are bonded with a fidelity bond. The fidelity bond protects against negligence or ill intent by employees, and the insurance covers any losses – namely your funds – from being stolen by dishonest employees.
Intermediaries receive payment either by charging a fee for their services or by charging no fees yet retaining a portion of the interest earned when the funds are in their possession. Some intermediaries charge a fee and take an interest, so you’ll need to ask your intermediary how they expect to be paid.
Another important point about your funds is that they not be dumped in a common account, but instead, be completely separate from other clients’ funds in an FDIC insured account.
This may seem like overkill, but it may save you millions of dollars. One of the most respected 1031 exchange companies, LandAmerica, filed for bankruptcy after the market for auction grade securities collapsed. When the company realized the implications of the problem, they immediately filed for bankruptcy, freezing $450 million dollars in funds meant for 1031 exchanges of 450 customers.
Furthermore, when the bankruptcy court finally gave a ruling five months later, almost all the 1031 exchange deals had expired, and the court ruled that only $50 million of the $450 million had to be returned to customers.
The rest was considered LandAmerica property and was used to pay off their creditors, leaving customers not only without their money but also liable for another $100 million in capital gains taxes.
This entire scenario could have been avoided with a segregated FDIC bank account, insured in amounts covered by the FDIC insured limits, and held in a qualified escrow account.
2. Add a Cooperation Clause in Your Sales Contract
Once you find a buyer for your relinquished property, you must be sure the contract includes an addendum stating that you intend to use the property as part of a 1031 exchange for which the buyer will not incur any additional expense or liability.
3. Provide a Copy of the Contract to the Intermediary
Once both the buyer and seller agree to the terms of the contract, a copy of the contract, along with the name of a phone number of the attorney handling the settlement, should be sent to the qualified intermediary.
The intermediary will then prepare several necessary documents, including the Escrow Account Agreement, Assignment of Contract, Exchange and Account Agreement, and Notification of Assignment. These will need to be signed and delivered before the settlement is completed.
4. Funds for the Exchange are Wired to the Exchange Account
In order to defer taxes, the IRS requires that the investor does not have ownership of the funds from the purchase of their property. Instead, the qualified intermediary holds the sale proceeds in an escrow account until the exchange is completed.
5. Find a Replacement Property Within 45 Days
Once the sale is of the relinquished property is complete, you have 45 days to find a replacement property. You can either identify three properties, or you can identify three properties whose total fair market value is not more than 200% or twice the value of the relinquished property.
Identifying properties can either be done with the help of the intermediary or through a broker; however, once the properties are chosen, you must identify each one in writing. But once the 45 day period is up, you may not identify any new replacement properties.
6. Close on Replacement Property
Remember, you have just 180 days from the closing of your relinquished property in order to complete the 1031 exchange, so the sooner you get started, the better.
Once you and the seller agree on the terms of the purchase contract, the intermediary will transfer the proceeds of the property you sold to the closing agent at the title company. This completes the exchange.
Report The Exchange
Although the exchange is complete, don’t forget to send all copies of your sale and purchase documents to your accountant, so the exchange can be properly reported the IRS on Form 8824, Like-Kind Exchange.
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