Going through the 1031 exchange process is a significant opportunity for investors. It allows the owner of an investment property to sell and buy a similar property in order to defer capital gains taxes. However, exchanges can be tricky, especially with the rules and specific timelines that need to be followed. Investors shouldn’t go down this route alone – so we’ve gathered the basics, including the professionals needed to successfully accomplish a 1031 exchange.
It’s important to note that a 1031 exchange timeline is strict. Your replacement property, or properties, must be identified within a 45-day period and you have to close within 180 days of your relinquished property’s sale date. Here are the ordered events of an exchange:
- Decide whether or not an exchange is for you
- Find your Qualified Intermediary (QI)
- Sell your Relinquished Property or Properties
- Identify Replacement Property or Properties
- Close on your Replacement Property or Properties
- Celebrate the completion of your 1031 exchange!
The 6 Steps of a 1031 Exchange Process
1. Talk to your Tax Preparer or Attorney
Talk to your trusted tax advisor to determine whether or not the 1031 exchange process is right for you. Some people believe that taking the tax deferment is their only option. Your tax preparer or attorney will talk with you about your current situation, future financial goals, and how an exchange can help with that.
2. Find a Qualified Intermediary
After you and your tax preparer decide that an exchange is the right decision, you need to find a Qualified Intermediary (QI). A QI is a person or persons who works under the U.S. Internal Revenue (IRS) Code for section 1031 and undertakes specified activities. According to the IRS, a QI is responsible for transferring the relinquished property (the property being sold) to the buyer. They are also responsible for transferring the replacement property (property you will acquire) to the taxpayer pursuant per the exchange agreement.
There is little regulation governing those entities, so do your due diligence. Be sure to choose someone who is experienced and thoroughly understands tax code as your QI. You’ll want a QI who has a fidelity bond and a solid errors policy in place, should you ever need it. A fidelity bond is a form of insurance protection, and an errors policy will protect your investment funds if something were to go wrong throughout the exchange process. You cannot sell your property without a QI. From the moment your property is on the market or pending, contact your QI to get your file set up and start your documentation. It is never too soon to let your QI know of a potential exchange!
3. Sell your Relinquished Property
Your QI will guide you through the rest of the process once you have a buyer and a written agreement to sell. Purchase agreement addendums, exchange contracts, transferring documents and closing statements are crucial documents. They need to be completed correctly for your exchange to be valid. Once you send your sales contract to your QI, they will prepare the documentation needed.
You will need to provide the contract of sale with the taxpayer’s intention clearly stated. This is what is known as the purchase agreement addendum. The exchange agreement is the most important documentation you need to provide. This is a written agreement between the QI and the taxpayer. It should be dated on or before the closing date of the relinquished property. If it is dated after closing day, your 1031 exchange will not be valid.
Once your property is sold, your funds go into either a trust or escrow, with the QI and you then have 45 days from closing to determine a Replacement Property.
4. Find a Replacement Property
Replacement Property (or Properties) come in all shapes and sizes. You may change the Property or Properties identified as much as you want to within the 45-day period. However, note that you must turn in your final Replacement Property to your QI by midnight of the 45th day. You can choose one of three rules when picking your Property or Properties: The Three Property Rule, the 200% Rule, or the 95% Exception Rule.
- The Three Property Rule will allow you to pick up to three Replacement Properties. There are no limitations in place for the value of the Properties. You can acquire one or more of the three as part of the exchange transaction.
- The 200% Rule gives you the opportunity to identify an unlimited amount of Properties, given that the total value of these properties does not exceed 200% of your Relinquished Property. For example, if you sell your Relinquished Property for $2,000,000, you could identify up to eight properties at a value of $250,000 per property.
- The 95% Rule allows you to identify as many Replacement Properties as you desire, exceeding the 200% limit, as long as you acquire at least 95% of the value of the Properties. This option is a bit riskier, because if you do not acquire 95% of the fair market value, the deal will fall through and your 1031 exchange will no longer be valid.
5. Close on Your Replacement Property
Timing is crucial throughout the 1031 exchange process. The closing for your replacement property must be completed within 180 days of the sale date of your relinquished property. Your QI should send out reminders to you about upcoming dates and be with you every step of the way. As with your sale, your QI will have documents and verifications that are needed for the exchange to be completed correctly and on time! Make sure to get a copy of the closing documents to keep for your tax records. When you file your taxes for the year, be sure to attach an IRS Form 8824!
6. You’ve completed the 1031 exchange process, now to celebrate your new investment!
You have so much to be excited about once your exchange is finished: your new investment properties, being one step closer to your financial goals, and that you completed the 1031 exchange process! There is no limit to the amount of exchanges you can do, so the sky is the limit. Be sure to continue to hire the right professionals so you can continue to go through the exchange process correctly.