Jennifer de Jesus

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1031 Exchanges — Tips for Success

Terry Pappy

Helpful links regarding 1031 Exchanges:

Please defer to your tax expert for advice regarding 1031 Exchanges.

How to navigate 1031 Exchanges

Deferring taxes on a gain from selling an investment property sounds ideal, doesn’t it? When your investment property has appreciated in value and you sell it, you have to pay tax on the gain. However, you can defer that gain using a 1031 Exchange. The Internal Revenue Code (IRC) Section 1031 allows you to defer taxes (not avoid) when transitioning properties, but you have to follow certain rules in order to have a successful. This tax rule enables investors to exchange one property for another property which in turn likely increases your portfolio size.

There are a lot of good reasons to do a 1031 Exchange:

  • Defer taxes on gains

  • Expand the markets you invest in

  • Have a more fluid, diverse portfolio

  • Acquire higher cash flowing properties

  • You can invest in more property types using the like-kind structure versatility

  • More flexibility and power to increase your investment portfolio

Use these tips to help you prepare in advance so 1031 Exchanges are a clear option to improve your overall real estate investing strategy.

Tip #1: Do you qualify for a 1031 deferral?

If you own investment property or business property, you qualify. You also qualify if you are a tax-paying entity such as an S corporation, C corporation, limited liability company, trust or individual.

Tip #2: What structure should you use?

When you want to exchange properties, the simplest is to exchange one property for another. However, there are other structures, such as a deferred exchange, which provide more flexibility in that you can exchange one property for one or more like-kind properties. Simply selling one property to use the proceeds to purchase another property is a taxable transaction. With a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. You will need to use an exchange facilitator under exchange agreements pursuant to rules provided in the Income Tax Regulations.

There’s also a reverse exchange, which is more complicated than a deferred exchange. You’ll have to acquire a replacement property through an exchange accommodation titleholder, and park it for less than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.

Tip #3: What are the time limits to defer tax liability?

Time limit #1 is that you have 45 days from when you sell a property to properly identify and clearly describe in writing potential replacement properties you wish to use for the 1031 Exchange stipulated in the IRS guidelines. Time limit #2 is that you must receive the replacement property and complete the exchange within 180 days of the sale of the exchanged property or due date of the income tax return for the tax year in which the property was sold, whichever is earlier. The property you’re purchasing must be substantially the same as what you identified in writing within the 45-day time limit #1.

Tip #4: What defines “like-kind?”

  • Both properties must be held for use in a trade or business or for investment, not personal use.

  • Both properties must be similar enough to qualify as “like-kind” which is defined as property of the same nature, character or class. Most real estate is like-kind to other real estate.

  • Both properties must be within the United States.

  • Real property and personal property both qualify, however, real property cannot be like-kind to personal property, as personal property includes more restrictions than real property.

Section 1031 does NOT apply to the exchanges of:

  • Inventory or stock in trade

  • Stocks, bonds or notes

  • Other securities or debt

  • Partnership interests

  • Certificates of trust

Tip #5: Know the restrictions (the fine print)

  • Taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all gain immediately taxable.

  • You cannot act as your own facilitator—your agent cannot act as your facilitator either, which includes real estate agents, brokers, investment bankers, accountants, attorney, employee or anyone who has worked for you in those capacities.

Tip #6: Secure a qualified intermediary

A qualified intermediary is instrumental in helping you navigate 1031 Exchanges. Make sure your intermediary has not declared bankruptcy or has a history of not being able to meet contractual obligations to their taxpayers. Intermediaries can help you manage your timelines and hold your proceeds so your transaction is not disqualified. 1031 Exchange intermediaries are also referred to as 1031 Exchange Accommodators.

With intermediary services, you enter into a contractual agreement with an independent entity (person or company) to facilitate the transfer of proceeds and they can be a helpful guide through the process. The average cost of doing a simple deferred 1031 Exchange is anywhere from $600 to $1500, most of which is for the intermediary’s services. Depending on the type of exchange you are doing (deferred vs. reverse) or complexity of other tax-related counseling you need, you could pay more, so budget accordingly. We highly recommend the use of our preferred provider, the 1031 Corp. You can find more information as well as valuable resources on their website 1031Corp.

Tip #7: Deferred doesn’t mean eliminated

Benjamin Franklin over 230 years ago said, “Nothing is certain except death and taxes.” Any financial gain is deferred, not forgiven, in a like-kind exchange. As you continue to leverage 1031 Exchanges, you need to keep track of your basis in the new property from the exchange when deferring the gain for later recognition by the IRS. Your intermediary and/or tax accountant can help you calculate and keep track of the basis figures.

There are other considerations you may need to make such as setting up a trust for heirs or other uses of your financial gains that a financial planner and appropriate real estate tax attorney can help you with. Having the right team is key to benefiting from all of the advantages that real estate investing affords.