The Basic Steps of 1031 Exchanges

1031 exchanges are a tax strategy that allows you to delay paying capital gains taxes on the sale of your property.  The biggest advantages are that you save money and have more cash to invest in another property. You must follow the rules under Section 1031 of the Internal Revenue Code for your exchange to be recognized by the IRS.  In 1031 exchanges, you are exchanging like for like property.  For instance, say you own a 12 unit apartment building, and you want to buy another 12 unit apartment building.  You sell your existing one and exchange it for the replacement property.  When you sell the exchange property, you pay tax on the gain at that time.  If during the exchange, you receive other non-like property (“referred to as boot”), you must pay the tax on the gain. It cannot be delayed.  Loss on non-like property is not recognized. A reverse 1031 exchange works just the opposite, and is more complicated.   You purchase the replacement property first, and then sell the existing property.  Before you consider doing a 1031 exchange, it’s a good idea to speak with a tax attorney.  

How the Process Works?

• You begin by selling your current property to a buyer.  In the purchase and sale contract you must identify that the buyer and seller agree to participate in a 1031 exchange.  There are no additional costs to your buyer. 
• Then you must notify the closing agent and all other parties such as attorneys and Realtors.
• You have to choose a qualified intermediary for your exchange, as defined under the IRS Code Section 1031. The intermediary will handle the required documentation, and will send it to the closing agent.  You can get a referral from your Realtor, closing agent or your attorney.
• After the sale, your sale proceeds must be sent directly to the intermediary.   
• Pursuant to the IRS rules, you are required to identify an exchange property in writing within 45 days after the sale of your existing property. You are allowed to identify three properties.
• You must complete the purchase of your new property within 180 days from the sale of your existing property to benefit from the tax deferment.
• After the closing on the replacement property, the intermediary will forward any excess sale proceeds from the relinquished property to you.    

Reverse Exchange 

The reverse exchange process works slightly different.  You close on the new property first, and then close on the existing one.  The IRS rules require that you complete the entire reverse exchange within 180 days of the date your intermediary acquires the replacement property for you.  A reverse exchange is a good investment strategy to use when real estate prices are down, and it is more difficult to sell an existing property and easier to find a good deal on a replacement property. 

Speak to a Tax Attorney 

It is recommended that you speak to a tax attorney who can explain the 1031 exchange process to you.  The attorney can answer all your tax questions.