A Safer 1031 Exchange Process
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First, what is a 1031 exchange? A 1031 exchange, allows an investor to defer paying capital gains taxes on the sale of an investment property, provided that the proceeds are reinvested in a similar or "like-kind" investment property.
The Process
Simplistically, the investment property is sold (known as the relinquished property), and the proceeds are used to purchase a replacement property or properties according to the rules and timelines specified by the IRS. The process is illustrated below.
Below are the two key dates for completing the 1031 process: the identification period end date and the maximum close date.
Technically, all you have to do during the 45-day identification period is identify up to three replacement properties. The issue arises when one or more of the identified properties do not close, resulting in the loss of tax deferment for these funds. Having completed over 80 1031 exchanges, we've established procedures to minimize the likelihood of this occurring. This is crucial when there are multiple replacement properties. The process we follow is illustrated below.
Once all contingencies for the relinquished property have passed, we place replacement properties under contract. We typically close the replacement properties within two weeks of the relinquished property closing. Therefore, if one of the properties falls through, we have enough time to secure another replacement before the 45-day identification period ends.
1031 Considerations
Below are some considerations that you should be aware of:
- Before listing the property to be relinquished, choose a 1031 exchange agent. They will provide important information, such as the total amount you need to reinvest. We can recommend 1031 exchange agents with whom we've worked.
- When you are buying the replacement properties, you are on a strict timeline. There can be no delays and no extensions. If you miss a timeline, you will likely pay capital gains. Additionally, when acquiring multiple replacement properties, you will need to balance the timeline against the properties available and do the best you can.
- The funds from the sale of the relinquished property must go from the closing escrow company to the 1031 exchange agent. If the funds are in your direct possession at any point, you will likely lose the tax deferment. When you buy the replacement properties, the funds will come from the 1031 exchange agent directly to the escrow company.
- You are not allowed to use the proceeds from the relinquished property to pay for renovations. Some of our clients have opted to pay capital gains tax on a portion of the proceeds and use that money for the renovation.
- Not all sale & purchase contracts include 1031 exchange verbiage. Have your listing agent obtain the correct verbiage from your exchange agent for your state and include it in the agent-to-agent remarks, specifying that the 1031 text must be included in the offer.
- If the relinquished property has a mortgage, it's important to determine how it will be handled during the exchange. Any reduction in debt or cash received may be treated as taxable boot, resulting in potential tax liabilities. Talk to your 1031 exchange agent.
- Both the relinquished and replacement properties must meet the requirement of being held for investment or used in a trade or business. Personal residences or properties primarily held for personal use do not usually qualify for a 1031 exchange.
- It's important to understand the state-specific regulations regarding like-kind exchanges. Some states may not recognize or fully conform to the federal provisions. Consult with a tax professional familiar with your state's laws.
Summary
If you work with an experienced team to purchase replacement properties and adhere to the process outlined above, the 1031 exchange process is simple and straightforward.
