Doing 1031 Exchanges Right
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’s the short explanation. But within that description, there are plenty of potential pitfalls you must consider or face the consequences. If you do a 1031 exchange wrong, you pay unanticipated taxes on your property’s sale.
Follow these steps to help make sure that doesn’t happen.
Assess Your Long-Term Goals
A 1031 exchange isn’t for every investor. If you need capital quickly, you might want to look elsewhere. A 1031 requires that you exchange your property for another, so you won’t cash out big.
Create an investment plan to better understand your long-term goals. It’ll help you determine which properties to look for as part of an exchange. And, it’ll help you budget out how these new properties will provide greater returns over time. In short, an investment plan helps you determine if a 1031 makes sense.
Taxes are no fun, but your goals might make it more profitable to pay taxes now and keep the capital. Or, it might be more profitable to build a sensible series of investments that pay well into the future.
Figure Out What Qualifies
You’ll almost certainly want to hire an expert to determine what types of property qualify for 1031 exchanges. Why?
According to the IRS, you may exchange “like-kind” properties. But that’s 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.
You must own this property. Not all interests in property are eligible. For example, a joint ownership of property through a fund or a REIT typically won’t qualify. A joint venture ownership of a property may not qualify either depending on its structure.
Don’t worry if you have trouble sorting this out on your own. Professional involvement is essential to make sure you properly define the exchange properties, since failure to do so will nullify the exchange and stick you with a hefty tax bill.
Know the Restrictions
Beyond property type, there are several other restrictions to consider. Knowing them well prevents you 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, you’ll still want to pay attention to it. If you exchange for a cheaper building, the difference may be taxed before it is returned to you.
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 you to find the perfect property at exactly the same time you wish to sell. This is why “deferred” exchanges are allowed.
That means you can “sell” your 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 you 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 can’t be you or someone who works for you.) These parties are often CPAs or attorneys who specialize in 1031 exchanges, which is essential since your entire exchange can be voided by the IRS if one dime goes into the wrong account.
Pull the Trigger Quickly
Once you have everything in place and sell, you need to move quickly. You have 45 days from the date you sell to identify the property you’d like 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, you must complete the exchange within 180 days of the sale.
Report the Exchange to the IRS
Once you’re done, you’ll 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, relationship between parties, property value, gain and loss, cash received, and more.
After that form is filed, congratulations! You’ve successfully completed a 1031 exchange. You’re on your way to a lighter tax bill and a larger real estate empire. These steps can help you think about, structure and execute 1031 exchanges, so that you can potentially reap the benefits.
But, you need to do it right, otherwise you can expect a knock on the door from the taxman. Individual tax situations can vary and can be complex. It is important to consult a tax professional to advise you on your specific situation. And this is one open house you can’t reschedule.