1031 Exchange for Asset Growth in 7 Steps
To get started, the 1031 Exchange gets its name from Section 1031 of the U.S. Internal Revenue Code. It allows an investor to defer paying capital gains taxes when selling an investment asset when meeting certain conditions. When the investor sells an asset and reinvests in another asset of like kind and meets certain other requirements, they are allowed to defer the capital gains taxes on the transactioni.
Why enter into a 1031 Exchange?
There are several reasons for entering into a 1031 Exchange transaction:
- A rental property may be approaching depletion of depreciation deductions. Selling it and rolling into another property starts depreciation over again.
- Timing the sale of a property to minimize taxes on recapture of depreciation.
- Perhaps rental returns have been dropping on one or more properties and the investor wants to take accumulated profits out by selling and rolling into other properties.
- Selling multiple properties to purchase one larger property for estate purposes.
There can be other valid reasons for a 1031 Exchange transaction. There are strict rules as to timing, relative values of the sold and purchased properties, and other rules. Here are 8 steps for a high level view of the 1031 Exchange process.
- Identify the property to be sold.
The property to be sold is identified by address and/or legal description. This information will be given to the qualified intermediary discussed in the next step.
- Choose a Qualified Intermediary (QI)
While the IRS allows other types of exchange facilitators, those designated as Qualified Intermediaries are considered the best resource for this transaction. You cannot handle any aspects of the transactions. Immediately turn over the address of the property selected for sale to the QI. They will facilitate the sale, secure the proceeds, and then complete the purchase transaction.
- Give Sales Contract & Relinquished Property Addendum to QI
When you get a buyer and sales contract, give that document and any earnest money check to the QI. Include with the contract a signed relinquished property addendum.
- Identify Replacement Properties
If you do not already have a property or properties identified to replace the sold property, a 45-day deadline begins at the closing of the sale of the relinquished property. You have 45 days to identify the replacement property(ies). You can identify multiple replacement properties, as you do not have to buy them all. You identify possible backups in case a purchase of preferred property(ies) cannot be negotiated.
- Copy of Purchase Contract to the QI
Once you negotiate and sign a contract or contracts on replacement property(ies), get the contract to the QI. You will also need an assignment contract assigning your rights and obligations under the purchase contract to the QI.
- Close the Purchase of the Replacement Property(ies)
You have up to 180 days from the contract date to close the purchase of the replacements, and you should try to stay well within this time limit.
- File IRS Form 8824
IRS Form 8824 reports the exchange to the IRS. It must be filed in the tax year in which the original property was sold.
This is just an overview, and it is strongly recommended that you consult with qualified tax advisors familiar with 1031 Exchanges.