If you’re an investor looking to reinvest proceeds from a property sale into a passive, real estate investment, it’s useful to know how to do it effectively and to stay compliant with the changing regulations.
Conducting a compliant 1031 exchange is all about careful planning and adhering to the strict IRS rules and timelines in place.
What’s a 1031 exchange mean for investors?
A 1031 exchange lets real estate investors defer capital gains taxes by being able to sell an investment property and then being able to reinvest the proceeds into another like-kind property.
This allows portfolio growth without immediate tax hits. However, as mentioned above, strict IRS timelines and rules are important to be aware of to swap one business/investment real estate with another similar type.
The benefits of 1031 exchanges for investors
There are some great benefits of 1031 exchanges for investors. These include the following:
- Tax deferrals – Avoid paying capital gains tax and depreciation.
- Portfolio growth – Allows for reinvestment of the full sale proceeds and enables expansion or upgrades to larger properties.
- Portfolio diversification – Switch from one type of property to another (single-family rental to commercial building).
- Management relief – Exchange high-maintenance properties for ones that are easier to manage, like triple-net lease properties.
Conducting a compliant 1031 exchange
So, how do you conduct a compliant 1031 exchange? Well, careful planning and adherence to strict rules and timelines via the IRS are crucial. You’ll also need a qualified intermediary (QI) as the investor cannot have a constructive receipt of the sale proceeds.
Here’s a step-by-step guide to a complaint deferred 1031 exchange for investors looking to do so.
Pre-sale planning and preparation
Pre-sale planning and preparation are crucial to get right and must be detailed at this stage. Here are a few steps to take in the pre-planning process.
Evaluate your goals and eligibility
It’s important to confirm that the property being sold and the one being acquired are both held for business or investment use. Personal residences do not qualify, so it’s imperative to be aware of this.
Consulting with a tax advisor or CPA is helpful to ensure the exchange will align with your financial strategy, as well as to estimate potential tax deferral.
It’s also useful to explore what 1031 exchange investing news is out there so that you’re well-informed before moving forward.
Engage a qualified intermediary
Selecting a reputable QI before the sale of a relinquished property is something that you’ll want to get done before it’s finalized. The QI acts will act as a neutral party to hold the sales proceeds, as well as prepare the necessary exchange documents. This will also help prevent you from touching the funds too.
Include exchange language in the contract
It’s important to ensure you have your purchase and sales agreements for both properties and include a clause notifying the other parties of the intent to perform a 1031 exchange.
The exchange process and timeline
The more you’re aware of the process and timeline, the more realistic your expectations are when it comes to a 1031 exchange.
The timeline for a deferred exchange will begin on the day that the relinquished property is sold.
Close the relinquished property
The sale closes, and the proceeds will be transferred directly to your QI and not to you. The QI will then send instructions to the settlement agreement as planned.
Identify replacement properties
It’s important then to know you’ll have 45 days from the closing date of the relinquished property to formally identify potential replacement properties in writing to your QI.
As such, you must also follow one of these identification rules as part of the process:
Three-property rule
This one identifies up to three properties of a value and is the most common identification rule to follow.
200% rule
Beneficial to identify more than three properties, provided their combined fair market value doesn’t exceed 200% of the relinquished property’s sale price.
95% rule
The 95% rule is where you identify an unlimited number of properties, but you must acquire at least 95% of the aggregate value identified.
Acquire replacement property rule
Lastly, you should be closing on one or more of the identified replacement properties within 180 calendar days of the relinquished property’s closing date.
This period will run concurrently with the 45-day identification period and cannot be extended. Even if the 180th day falls on a weekend or holiday, it must be completed within that timeframe. No exceptions.
Post-exchange and compliance
At the point of post-exchange, compliance is still important to be aware of. To achieve a full tax deferral, the value of the replacement property must be equal to or greater than the value of the relinquished property. This is the property price minus closing costs.
Receiving cash or a reduction in the mortgage dept this isn’t offset by new debt or additional cash input, will result in ‘boot’ which is taxable.
It’s important to note that the title to the replacement property must be in the same legal name(s) as the relinquished property. Otherwise, this can cause compliance issues.
When reporting to the IRS, you’ll need to report the exchange by completing and filing IRS Form 8824 with your federal income tax return for the year in which the exchange occurred.
The most important part of a 1031 exchange is remaining compliant at all parts of the process. Being up to date with changes in rules and regulations is paramount, which is why you must take advantage of all the resources available online.
The benefits of a 1031 exchange are certainly something to consider as an investor, especially if you’re looking to defer capital tax payments. It’s beneficial to explore this to help grow and diversify your portfolio.
If you have any queries about this process, then it’s worth checking in with a professional (QI) to get all of the details on how it works and how best to go about it if it’s your first time.
