Deferred 1031 Exchanges: What You Need to Know
A 1031 exchange is used by savvy real estate investors to defer paying capital gains tax on the sale of an investment property. It does this by exchanging the first property for a second property the investor wishes to purchase. This rolls the tax one would have originally paid on the sale into the new property, deferring it until the sale of that property.
Effective use of 1031 exchanges allows investors to leverage the proceeds of an investment property sale to build bigger real estate portfolios. For instance, if you sold a building for $500,000, you would lose, say, $150,000 to taxes. With a 1031 exchange, you might be able to use the entire half a million dollars to purchase one or more properties. Normally, you would have $350,000 after taxes on a sale with which to potentially buy property in the future. With a 1031 exchange, your purchasing power goes up almost 43%.
That sounds like a pretty good deal—and a deferred 1031 exchange is one way to potentially help you achieve it.
Technically, 1031 exchanges should happen immediately upon sale of your initial property. But, this isn’t always feasible. 1031 exchanges require you to exchange one property for another “like-kind” property. According to the IRS, a “like-kind” property is:
“Property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.”
The definition is vague. It may take time to find and secure the right like-kind property. In fact, many investors secure two or three properties in case the first falls through. A deferred 1031 exchange gives you the time to do this, since many investors don’t have like-kind property ready to exchange the moment they sell.
The deferred 1031 exchange gives you time by allowing you to “sell” your first property to an intermediary, who then “buys” the property on the other end of the exchange at a later date. This keeps the entire series of actions as one transaction, which makes it eligible for a 1031 exchange, albeit a “deferred” one.
Deferred 1031 exchanges are the same as any 1031 exchange, except they come with some additional restrictions.
Says the IRS, “The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.”
But even with the deferment, the whole property exchange must be completed no later than 180 days after the sale.
To facilitate this transaction, investors often use qualified intermediaries, commonly known as 1031 Accommodators, to facilitate the exchange.
1031 Accommodators typically know the ropes and many specialize in 1031 exchanges. You cannot act as your own accommodator, nor can your real estate agent, broker, banker, accountant or attorney. You must be very careful with vetting your 1031 Accommodator. Says the IRS:
“Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain.”
Like any 1031 transaction, any error during a deferred 1031 transaction means the entire sum is taxable by the IRS, so doing it right is essential for investors.