How to Do a 1031 Exchange Right the First Time
A 1031 exchange is a tax strategy that allows investors to sell an investment property in exchange for another property, then defer capital gains from the first property’s sale. This strategy is advantageous for investors who wish to purchase more real estate rather than cash out.
That is a short explanation. There are plenty of potential pitfalls investors must consider or face the consequences. For example, if an investor does not complete a 1031 exchange correct, they may need to pay unanticipated taxes on their property’s sale. Follow these steps to help make sure that does not happen.
1. Assess Your Long-Term Goals
A 1031 exchange is not for every investor. If an investor needs capital quickly, they may might want to look elsewhere. A 1031 requires exchanging one property for another, which means that cashing out big is unlikely.
2. Create an investment plan to better understand your long-term goals.
This may help an investor determine which properties to look for as part of an exchange. It will also help with budgeting and to figure out how these new properties will provide greater returns over time. In short, an investment plan helps an investor determine if a 1031 makes sense.
3. Evaluate your taxes
Taxes are no fun, however it may be more profitable to pay taxes now and keep the capital. On the other hand, it might be more profitable to build a sensible series of investments that pay well into the future.
4. Figure Out What Qualifies
Any investor will almost certainly want to hire an expert to determine what types of property qualify for 1031 exchanges. Why?
According to the IRS , properties that qualify for a 1031 exchange must be “like-kind”, which has a flexible definition. On the surface, the IRS says the properties must be “similar enough” to qualify as like-kind, but “quality or grade does not matter.” Under these rules, a vacation rental home that was built on a plot of land is like-kind to a vacant plot of land.
5. You must own the property
Not all interests in property are eligible. For example, a joint ownership of property through a fund or a Real Estate Investment Trust (REIT) typically will not qualify. A joint venture ownership of a property may not qualify either depending on its structure.
6. Involve Professionals
An investor can approach a 1031 exchange on their own. However, professional involvement is essential to make sure investors are able to properly define the exchange properties, since failure to do so will nullify the exchange and stick the investor with a hefty tax bill.
7. Know the Restrictions
Beyond property type, there are several other restrictions to consider. Knowing them well prevents investors or the other party from violating the exchange’s rules.
One major restriction is that 1031 exchanges only work in real estate for investment properties, not personal ones. These properties must be in the United States. Also, while there are no restrictions on property price, it should be paid attention to. If an investor exchanges a property for a cheaper building, the difference may be taxed before it is returned.
8. Understand the Structure
How the 1031 exchange is structured matters. One type of 1031 exchange occurs immediately, meaning the sale of both properties occurs simultaneously. That is difficult to enact. It requires an investor to find the perfect property at exactly the same time the investor wish to sell. This is why deferred exchanges are allowed.
That means an investor can sell a property to an intermediary, who then buys the property on the other end of the exchange. This ensures that the entire series of actions remains one transaction, rather than receiving taxable cash for the sale.
According to the IRS , “taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements.” This is because these parties know the ropes and because there are restrictions on the type of intermediary you can use. (For instance, it cannot be the investor or someone that works for the investor.) These parties are often CPAs or attorneys who specialize in 1031 exchanges, which is essential since the entire exchange can be voided by the IRS if a single dime goes into the wrong account.
9. Pull the Trigger Quickly
Once everything is in place and a property is sold, an investor needs to move quickly. They have 45 days from the sale date to identify the property which they wish to buy. This identification must be written down by someone involved in the deal. Typically, investors identify three properties to give themselves backup plans if their first choice falls through.
Then, the investor must complete the exchange within 180 days of the sale.
10. Report the Exchange to the IRS
After the exchange is complete, an investor will need to report the exchange to the IRS using Form 8824 in the year in which the exchange has occurred. According to the IRS , Form 8824 asks for property descriptions, the relationship between parties, property value, gain and loss, cash received, and more.
After that form is filed, the investor would have successfully completed a 1031 exchange. The investor will be on their way to a lighter tax bill and a larger real estate empire.
These steps can help investors think about, structure, and execute 1031 exchange, so that they can potentially reap the benefits. However, a 1031 exchange needs to be done correctly. Individual tax situations can vary and can be complex. It is important to consult a tax professional to advise on a specific situation.
As with all investing, investors should understand the risks associated, and nothing is guaranteed.