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Have you heard about 1031 real estate exchanges? It turns out they are a great way to save money on taxes. You may not realize this, but paying income taxes on the disposition of rental, business, or investment real estate is voluntary. You have another option!
Even people who have heard of 1031 real estate exchanges often don’t take advantage of them. Perhaps it’s because the name makes it sound like something too difficult to mess with. The truth is that the process is simple; don’t let the word “exchange” fool you.
The Basics of the 1031 Exchange
Here is what you need to know: the Section 1031 tax-deferred exchange is merely a sale and a purchase. It involves four parties: 1) the seller (you), 2) the buyer, 3) the seller of your new property, and 4) a qualified intermediary who knows how to qualify your sale and purchase as tax-deferred. The process requires only a few necessary steps:
- Hire an intermediary.
- When you sell to the buyer, the intermediary holds onto the money. Don’t touch the money yourself.
- You then purchase your new property using the funds being held by the intermediary.
- All of the taxes are deferred as long as you receive no cash and do not obtain debt relief!
Who Can Act as Intermediary
For your sale and purchase to qualify for tax-deferred status, your intermediary must be someone impartial who does not benefit from the exchange. Specifically, you cannot have had a business relationship with the person in the last two years[1]. That means the ordinary people you may think of to help with your finances—your attorney or accountant—won’t work.
Don’t get discouraged. Professional intermediaries are available who specifically handle these kinds of situations on a daily basis. You can do a quick online search for “1031 intermediary” and find plenty of candidates. Because they are fairly common, you can usually get a fairly good price (perhaps less than $500) on hiring an intermediary.
Tip: Be aware that like any purchase of services, hiring an intermediary does carry risk. They are a business, and although it’s not common, it is possible to come across dishonest intermediaries who steal their clients’ money. Be sure you check the company’s background. Also, intermediaries can go bankrupt. This would entirely throw off your sale and purchase if the funds from the first sale are missing. That means you won’t be able to complete the exchange. You’ll have to pay the taxes, and you won’t have the money from the sale—bad news all around.
Most professional intermediaries are legitimate companies that make their money through helping clients to save on taxes. However, you should always protect yourself and your investments. Make sure you go with a company with an established reputation, and check into options to protect your money, such as bonds or an insurance policy. Also, ask the intermediary if they offer some type of protection for your funds.
Time Limits on Making an Exchange
Okay, so most of this doesn’t sound too complicated. Don’t let the simple process make you get lax. Section 1031 sets hard, fast rules about how long you can take to complete an exchange. Be efficient; meet the deadlines. If you don’t, you lose out on your tax-deferred advantage, no exceptions or second chances. Here’s the information you need:
- Start Date—The date on which you close the sale for the property you are selling triggers the “initial transfer date”. Once you have relinquished the property, the Section 1031 exchange officially begins.
- Identify Date—Yes, you have a time limit on how long you can take to identify the property you intend to buy. You should formally identify your possible choices by the forty-fifth day after the initial transfer date[2]. Please note that this is not the date by which you must purchase the property; you merely need to have a few specific options picked out.
- Close Date—The close date is not the day you close the sale on your new property. It is actually the date on which the exchange is fully completed and you have identified the new property title in your name. The closing of the exchange must be completed within whichever of the following two time frames is shorter[3]: 1) 180 days after the initial transfer date, or 2) the due date of your tax return.
Before you begin to panic, remember that you are allowed to extend the due date of your tax return. You may even be able to get the full 180 days by extending your return. So, if your exchange closes after October 17, file the extension to get more time to complete process.
Other options also exist to buy you a little time. When you know it may take a while to find a suitable replacement property, you can delay the start date. How? One way is to offer your potential buyer a triple net lease to occupy the property until you’re ready to close[4].
How to Prove Identification
You may have noticed that you need to formally identify a property by the forty-fifth day after initial transfer. Ugh, more paperwork, right? Fortunately, it’s easy enough to record your identification of a property. Just put down the earnest money, and you have your evidence that purchase of the replacement property is in process. If you haven’t put down earnest money, you’ll have to sign a document that you provide to the qualified intermediary[5].
Keep in mind that you’re allowed to identify up to three replacement properties regardless of fair market value, whether you’re selling one or multiple properties[6]. You can identify more than three new properties if the total fair market value of the properties does not exceed 200 percent of the fair market value of the properties you sold. The deadlines may be strict, but these rules allow plenty of flexibility in choosing new properties. Even better, the Section 1031 rules work for pretty much any real estate (rental buildings, vacant land, business facilities), as long as it’s domestic and not for personal use[7].
In fact, you can even build on vacant land or rehab a building with a build-out or construction exchange[8]. When identifying the replacement property, you simply include plans for the structure or build-out you will have constructed (make sure this is completed within the designated 180-day period). The qualified intermediary then pays out the funds to the contractor as work is completed.
All you have to remember to qualify for tax-deferral is that all of the proceeds from your original sale must be used to acquire a replacement property. Do not collect cash on the deal. Do not attempt to reduce your debt through the exchange. If the property you purchase is a fixer-upper and did not cost the full amount you sold the original property for, simply complete enough improvements (through your intermediary) within the 180 days in order to use up all the funds. Otherwise, you have all the same options for selling real estate that you normally would, including owner take-backs[9], also completed through the intermediary.
Special Rules about Buyers and Sellers
You may be wondering if certain individuals, like relatives, are excluded from taking part in the sale and purchase. The good news is you are allowed to make the exchange transaction with someone you are related to, but you will be disqualified for tax deferral if an exchanged property is sold again within the next two years[10]. This only applies in cases of siblings (full and half), parents, grandparents, spouse, and descendants (biological and adopted)[11]. Entities in which you own (directly or indirectly) more than fifty percent in value are also considered related parties for this purpose.
Selling a property is not always easy. You’ll be happy to know that Section 1031 also allows “reverse exchanges”[12]. This simply means your intermediary can buy the new property with money you put up in advance before you have sold your original property. Be aware: the 180-day time frame still applies, with the start date taking place once you close on the new property. You’ll need to sell your original property by then to avail the tax advantage.
If you’d like to take advantage of these tax savings, be sure to contact a knowledgeable intermediary who can ensure the correct process is followed. Special rules exist for particular types of property, such as those being converted to rental properties, so make sure you’re working with someone who has experience with your type of situation and understands all the details. The rules get more complicated when you start trying to exchange personal property (e.g., office equipment) or intangibles like a business personality. Keep it simple with real estate exchange to get maximum return for the least effort.
- Reg. Section 1.1031(k)-1(k). ↑
- IRC Section 1031(a)(3)(A). ↑
- IRC Section 1031(a)(3)(B); Reg. Section 1.1031(k)-1(d). ↑
- Private Letter Ruling 8118023. ↑
- Reg. Section 1.1031(k)-1(c)(2). ↑
- Reg. Section 1.1031(k)-1(c)(4)(i). ↑
- IRC Section 1031(h). ↑
- PLR 200842019. ↑
- IRC Section 453(f)(6). ↑
- IRC Section 1031(f)(1). ↑
- IRC Sections 1031(f)(3); 267(b); 707(b)(1). ↑
- Revenue Procedure 2000-37. ↑