Here Are the Do’s and Don’ts You Need to Pull Off a 1031 Real Estate Exchange
A 1031 exchange is a practice named after a section of the IRS tax code. It allows taxpayers to potentially defer capital gains taxes from the sale of a property if they meet certain conditions. Those conditions can be complicated, tricky, and confusing.
To make sure you’re on the right path, pay close attention to these do’s and don’ts as you set up a 1031 exchange.
Do’s
1. Do understand what a 1031 exchange is. They allow you to exchange one piece of real estate for another and defer capital gains taxes when you sell the first property.
2. Do know that 1031 exchanges aren’t just for investment real estate. They encompass a variety of properties. But, some property doesn’t qualify, says the IRS, and that includes:
- Inventory, stock in trade.
- Stocks, bonds, other types of notes.
- Securities, debt.
- Partnership interests.
- Trust certificates.
For the purposes of this post, we’ll talk only about 1031 real estate exchanges.
3. Do understand the property you’re dealing with. 1031 exchanges happen between “like-kind” properties. This definition is vague. Says the IRS:
4. Do secure the help of a tax professional. A tax professional can definitively tell you if a property is like kind and assist you in understanding the requirements that must be satisfied for a successful 1031 exchange.
5. Do understand your investment goals. 1031 exchanges are ideal for investors who can afford to keep their available capital illiquid. These individuals may already be planning to buy more buildings or have no desire to transition their capital to other investment vehicles.
6. Do know you’ll probably need to defer your exchange. You’ll likely need to identify and secure a like-kind property after you sell. Investors typically identify up to three properties in case their first choice doesn’t pan out. Sometimes, investors perform the exchange immediately upon sale, though this is often difficult.
That means you’ll perform a deferred exchange. An intermediary party will hold the funds from your sale. If you touch the proceeds of the sale before the exchange is complete, you’ll end up paying taxes on them.
7. Do report the exchange using IRS form 8824 in the year the exchange was made.
Don’ts
1. Don’t try to exchange a piece of personal property. 1031 exchanges can only be done between investment properties that you own, which means REITs, funds or an LLC that owns shares in another LLC don’t qualify. Says the IRS:
2. Don’t try to exchange properties outside the U.S., as these do not qualify for 1031 exchanges.
3. Don’t take control of any cash before the exchange is done. This may cancel the exchange and make all gain “immediately taxable,” says the IRS.
4. Don’t delay after you sell the first property in the exchange. You must identify the property you’re receiving from the exchange in 45 days.
5. Don’t delay completing the exchange. Even once you identify a property, you need to complete the exchange within 180 days after the sale.
6. Don’t exchange for a cheaper property without running the numbers. If the new property is worth less, the difference in cash may be taxed.
7. Don’t forget to vet your intermediary in a deferred deal. They are not all created equal. The IRS highlights several schemes that occur:
8. Don’t try to act as your own intermediary. Under IRS rules, you, your family, or anyone who works for you can’t be the intermediary in these deals.
9. Don’t be fooled into thinking capital gain taxes are forgiven. They’re not. They’re deferred until the time you sell the next property unless you conduct another 1031 exchange with that property.
While these are some helpful suggestions, individual tax situations can vary and can be complex. It is important to consult a tax professional to advise you on your specific situation. Want to learn more about 1031 exchanges in real estate? Check out our other resources on the subject: