The ability to defer capital gains tax on the profits from the sale of one investment property when purchasing another in a 1031 exchange has made using it a favorite activity among savvy investors. You may be familiar with the fact that the 1031 exchange is an incredible capital-saving opportunity, however, if you’re still unclear how to take advantage of the IRS’s tax incentive, then this guide is for you. Not only will you learn what a 1031 exchange is, but it will also allow you to walk you through the steps towards completing a 1031 exchange successfully.
What is a 1031 Exchange?
A 1031 exchange allows you to defer capital gains tax on the profits from the sale of an investment property. The tax deferral works only when you exchange a property you already own with a different, newly purchased 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 an office building for a triple-net (NNN) ground lease, a residential rental for a dollar store, or a multi-family 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.
When embarking on a 1031 exchange, you have 45 days to identify, in writing, a replacement property, and 180 days to complete the transaction – no exceptions. If you choose a replacement property on 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 then the remaining sum of money, termed “boot,” will be subject to taxes.
Steps to Successfully Complete a 1031 Exchange
1. Identify Your 1031 Exchange Objectives & Property Search
At Westwood Net Lease Advisors, we tell our clients that the very first step in a 1031 exchange is to identify your objectives and start the property search before you either list your original property for sale or before it’s under contract.
If you wait until your property sells to start the 1031 exchange process, it might be too late to find exactly what you’re looking for and legally identify which properties you intend to purchase in that 45-day window, which can be costly. Our most successful investors pre-plan and maximize the tax-deferral opportunity.
2. Find a Qualified Intermediary
According to the IRS, you as the investor are not allowed to execute a 1031 exchange on your own. Instead, it must be accomplished through a qualified intermediary. 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. If you choose to work with a Westwood Net Lease Advisor, our referral network of qualified intermediaries is vast – we can assist you in finding one you can trust.
What makes a qualified intermediary?
- Usually, intermediaries are financial 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.
- Whether an intermediary is sufficiently qualified depends on whether or not he or she has had 1031-exchange training and has successfully completed numerous 1031 exchanges with the property types you own or plan to own.
- Intermediaries can voluntarily complete certification for becoming 1031 Exchange specialist, as well as become a member of the FEA, or Federation of Exchange Accommodators.
- 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 him or her to discuss your investment needs and determine the best plan for concluding the exchange successfully.
- Make sure to ask if the intermediary is 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 he or she expects to be paid.
Intermediary & Handling of Your 1031 Exchange Funds
Another important point to consider when choosing an intermediary is about your 1031 exchange funds. Ensure your money is not dumped into a common account, but instead, remains completely separate from other clients’ funds in an FDIC insured account.
This may seem like overkill, but it could 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, it 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 if investors had requested their funds be in segregated FDIC bank accounts, insured in amounts covered by the FDIC insured limits, and held in qualified escrow accounts.
How your funds are handled is critical – once you sign an agreement with an 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 your original property, purchase the replacement property, and execute all required transactions and contracts necessary to qualify for a 1031 exchange. But don’t worry, the qualified intermediary doesn’t actually hold the title to either property.
It all sounds very confusing, but now you know what to look for in a qualified intermediary, one who is trustworthy and knowledgable in your type of 1031, and you know how to ask for your funds to be handled. When it comes to the minutiae, your intermediary will walk you through the steps so you don’t have to worry about every detail. If you choose to work with a Westwood Advisor, we handle as much as we can legally handle on your behalf so there is less burden on you throughout the transaction.
3. Add a Cooperation Clause in Your Sales Contract
Once you find a buyer for your property, the sales contract must include 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 you, as the seller, and the buyer of your property agree to the terms of the contract, a copy of the contract, along with the name and phone number of the attorney handling the transaction, 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 you (the investor) do not have ownership of the funds from the sale. Instead, your qualified intermediary holds the sale proceeds in an escrow account until the exchange is completed (as noted above – ensure it is a separate FDIC insured account).
5. Find a Replacement Property Within 45 Days
Once the sale of the relinquished property is complete, you have 45 days to identify 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 your intermediary or through a Westwood Net Lease Advisor; however, once the properties are chosen, you must identify each one in writing. Once the 45-day period is up, you may not identify any other replacement properties.
6. Close on Replacement Property
Remember, you have just 180 days from the closing of your original property in order to complete the 1031 exchange, so the sooner you get started, the better. Once you and the seller of your newly chosen property agree to 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 to the IRS on Form 8824, Like-Kind Exchange.
Westwood Net Lease Advisors Simplify 1031 Exchange Transactions
As you can see, comprehensive knowledge and experience of the 1031 exchange process are necessary for acquiring the right property for your goals in the short timeline required by the IRS. It can be overwhelming for a first-time investor. That’s why it’s best to use a reputable Westwood Net Lease Advisor as your personal representative. Our team provides you with personal representation, peace of mind, and a much easier 1031 transaction. In fact – simplifying 1031s is our specialty.
Not only are we the only NNN investment specialists in the nation who primarily represent buyers, we also represent our clients from the pre-property search all the way through closing, at no cost to our buyers.
To Wrap it Up – the Step-by-Step 1031 Exchange Process Just Got Easier
When you invest in commercial real estate, it is imperative to know what is expected of you and how to go about making the most of every tax opportunity, including the 1031 exchange. If you should want to perform a 1031 on your own, we hope this step-by-step guide has been helpful. However, if you would like to free up your time and feel secure in your 1031 exchange investment decisions, we recommend working with an advisor.
Nothing outweighs the benefits of a specialized 1031 advisor when it comes to investing your hard-earned money and preserving capital in the process. Our Westwood Net Lease Advisors team is passionate about helping our clients utilize the 1031 exchange with the least amount of stress and the most favorable outcome. Contact us today for a free 1031 consultation, 314-997-5227.