A 1031 exchange is a swap of one real estate “investment” property for another that allows capital gains taxes to be deferred. To avoid the pitfalls many investors make, it’s wise to do your research before even considering a 1031 exchange. There are timelines and rules that need to be adhered to and if you wait until after you sell your home, it is likely too late.
Here are some basics to get you started:
- Listing the Property: First, the property you want to sell, known as the "relinquished property," is put on the market for sale. Once you have a buyer and the property is under contract, the exchange process begins.
- Finding a Qualified Intermediary (QI): You need to identify a qualified intermediary (QI), who can be an independent party or an institutional entity. The QI's role is crucial because they will hold the funds from the sale of your relinquished property until you find a replacement property. It is important to have a QI before closing the sale, as not having one will disqualify you from the exchange.
- Identifying a Replacement Property: Within 45 days of closing the sale on your relinquished property, you must identify a replacement property. Notify your qualified intermediary within this timeframe about the property you have chosen.
- Closing the Deal: The purchase of the replacement property must be completed within 180 days from the closing of the relinquished property sale. Remember that the timeframe is based on the sale closing and not the identification of the replacement property. It is advisable to wait until the exchange is complete before filing your annual taxes for the relevant calendar year since you cannot amend a tax return to include the exchange.
- Consultation with Tax Advisor or CPA: Once the exchange is finalized, it is important to consult with a tax advisor or certified public accountant (CPA) who can assist in preparing the necessary forms for filing.
Important points to consider regarding 1031 exchanges:
- Unlimited Exchanges: There is no limit to the number of times you can perform a 1031 exchange, allowing investors to continually defer taxes on property sales.
- Like-Kind Requirement: Properties involved in the exchange must be considered "like-kind" according to the IRS. They should be used for investment or business purposes. Specific limitations apply to vacation homes and secondary residences.
- Flexibility in Exchange Structure: The exchange doesn't have to be a direct swap of one property for another. It is possible to involve multiple properties or even utilize a "delayed exchange" where a qualified intermediary temporarily holds the funds during the transition.
- Limitations on "Stock in Trade": Properties considered as "stock in trade," such as homes built and sold by developers or properties immediately flipped after improvements, are ineligible for a 1031 exchange. The property must be held for investment purposes, and an immediate attempt to use it for another exchange may disqualify it.
- Exclusions of Personal and Intangible Property: Only real estate qualifies for a 1031 exchange. Personal property and intangible assets, such as stocks or bonds, cannot be exchanged under this provision.
- Price Disparity and Tax Considerations: If there is a difference in price between the exchanged properties, with one property being purchased at a lower value, tax implications arise from the disparity.
- Mortgage Liabilities: If mortgage liabilities are exchanged, any reduction in debt compared to the previous liability is considered "boot" and may be subject to capital gains tax.
- Consultation with Professionals: It is crucial to involve a professional intermediary, such as a tax advisor, financial planner, or CPA, well in advance of the exchange. They will ensure compliance with the IRS rules, deadlines, and qualifications associated with 1031 exchanges.
While a CPA would be best to help ensure compliance, a Real Estate Agent with experience in 1031 exchange is the first step to help you ascertain market values and guide you through this process.