Real estate investment can be a high-risk, high-reward environment and investors look for strategies to make the biggest return on their investment. One strategy real estate investors can utilize is 1031 exchanges. 1031 exchanges, also known as like-kind exchanges, are based on authority found in Section 1031 of the Internal Revenue Code and are used to defer capital gains taxes when selling one investment property and acquiring another like-kind property. Before tackling this time-consuming and complex strategy, investors should review the following six tips for 1031 exchanges:
- Understand the requirements: To qualify for a 1031 exchange, both the relinquished property (the property being sold) and the replacement property (the property being acquired) must meet certain criteria. The properties must be held for investment or business purposes, and they must be of like-kind, which generally means they are of the same nature or character.
- Engage a qualified intermediary: Investors need to work with a qualified intermediary (QI) to facilitate the exchange. The QI is an independent party who assists in coordinating the exchange and holds the funds during the process. The QI cannot be a relative, your attorney, banker, employee, accountant, or real estate agent. It is crucial to engage a QI before closing on the sale of the relinquished property.
- Sell the relinquished property: The investor sells the relinquished property and ensures that the proceeds from the sale go directly to the QI and not to their personal account. If the seller takes control of the cash proceeds of the sale the deal may be disqualified from a 1031 exchange and the profits will become taxable. The QI holds the funds in a segregated account until the purchase of the replacement property.
- Identify replacement properties: Within 45 days of selling the relinquished property, the investor must identify potential replacement properties in writing to the QI. The IRS provides specific identification rules that must be followed, such as identifying up to three properties regardless of their value or any number of properties with a total fair market value that does not exceed 200% of the relinquished property’s value.
- Purchase the replacement property: The investor has 180 days from the sale of the relinquished property to complete the acquisition of the replacement property. The QI uses the funds from the sale to purchase the replacement property on behalf of the investor.
- Complete the exchange: Once the replacement property is acquired, the QI transfers the title to the investor, and the 1031 exchange is completed. The investor can defer paying capital gains taxes that would have been due if a regular sale occurred. The 1031 exchange is required to be reported to the IRS using Form 8824 with the tax returns for the year the exchange occurred.
The 1031 exchange process is full of complex requirements and timelines that can trip investors up should they attempt to go through the process on their own. Therefore, investors should consult with their legal counsel and tax advisors to ensure compliance with IRS regulations and to maximize the benefits of the exchange.
