1031 Exchange For Dummies: 8 Steps To Skip Taxes

You found this article because you searched “1031 Exchange for Dummies,” – so I’ll walk through these powerful tax-deferral real estate strategies plainly. 1031s allow investors to sell properties, reinvest the proceeds into new buildings, and defer capital gains taxes in the process.

I’ve used 1031 exchanges to grow my real estate portfolio from $100k into $15 million worth of property over a decade without paying capital gains taxes along the way.

In this quick read, I’ll define 1031 exchanges, share the key rules around proceeds and timelines, and provide a simple step-by-step overview of the entire exchange process. With an understanding of the basics, you can build wealth through larger, tax-deferred real estate transactions.

Key Takeaways

• Swap one investment property for another to delay paying taxes on profits.

• You have 45 days to pick a new property and 180 days to buy it.

• Use a qualified intermediary to hold your money and keep the swap legal.

What is 1031 Exchange?

A 1031 exchange is the IRS giving you the green light to swap one investment property for another. This rule lets you defer paying taxes on any profit you’ve made from the first sale. This means you can use all that extra cash to invest in your next property.

It’s a big reason why so many real estate investors have seen their portfolios balloon over time. But there’s a catch – you’ve got a 1031 exchange timeline to stick to. So, while it’s a great opportunity, it requires planning to make sure everything lines up.

Key Steps in the 1031 Exchange Process

So, how does the 1031 exchange process work? Here are the eight key steps involved in the 1031 exchange process:

Step 1: Plan and Consult

So, you are considering selling your property? Before you do, meet with a tax advisor or 1031 exchange specialist. See if your transaction qualifies for a 1031 exchange. You’ll want to understand the implications for your specific situation.

Also, assess the market when thinking about an exchange. Can you find a replacement property within the 1031 exchange timeline?

When I sold an apartment complex in 2016, I couldn’t find a replacement multifamily property. I didn’t like the CAP rates I was seeing and didn’t think any of the properties were worth the price.

I debated foregoing the exchange and paying capital gains tax instead. But my broker suggested looking into other asset classes. This led me to a successful hotel partnership and more hotels through syndications. This is how I ended up in hotels, which has been a great path for me.

Step 2: Sale of Your Property

Let’s say you have decided to move forward with a 1031 exchange; the next step for a property owner is to sell your current property. At this point, your original property becomes known as the “relinquished property.” This is the first official step in the process, as it sets the 1031 exchange in motion.

Step 3: Find A Qualified Intermediary (QI)

The IRS specifies that you must use a Qualified Intermediary to hold the earnings from the sale of the relinquished property. The QI becomes a neutral third party to facilitate the exchange. They’ll hold your funds from the sale proceeds and then apply to your new property during closing.

Step 4: Identify Replacement Property

After your relinquished property closes, you now have 45 days. This is your timeline to identify potential replacement properties. This identification must be in writing and delivered to the QI.

It’s a good idea to identify several potential replacement properties to be safe. But, there are specific rules around the properties you identify. Here are the primary rules to follow:

Like-Kind Property

“Like-kind” refers to the nature of the property rather than its grade or quality. Most real estate is like-kind to other real estate. Just note that the relinquished and replacement properties must be for investment purposes.

For example, you can use a 1031 exchange to sell an apartment building and buy raw land or an office building for a retail space.

How many potential replacement properties can you identify? There are 1031 rules around this as well:

• Three Property Rule: Under this rule, you can identify up to three properties without worrying about their total market value. This is the most common choice among investors.

• 200% Rule: If you decide to identify more than three properties, add up the total market value of all the properties. That amount cannot exceed 200% of the total market value of the relinquished property.

• 95% Rule: If you exceed the limitations of the 200% rule, you must buy at least 95% of the value of all identified replacement properties. Its stringent requirements make this rule less commonly used.

You’ll need to provide written identification of the replacement properties to the QI. It needs to happen by midnight on the 45th day following the sale of your relinquished property. This timeline is strict, with no extensions for weekends or holidays.

Step 5: Deadline for Acquisition

Now, the clock starts ticking with a 180-day countdown. This begins from the moment you sell your old property, and it runs until the tax filing deadline—whichever comes sooner. That’s your window to close on one or more of the identified replacement properties.

In this 1031 exchange timeline, you’ll be conducting due diligence on your potential replacement property. If you find that the investment properties you are looking at do not meet your criteria, don’t feel forced to buy something.

If things aren’t lining up and the properties aren’t a perfect match, don’t sweat it. There are other options like a Delaware Statutory Trust or a Deferred Sales Trust. These paths can be pretty slick alternatives, and I’ll walk you through both in a bit, so stay tuned.

Step 6: Close On Replacement Property

Purchase the replacement property through the QI, using the proceeds from the sale of the relinquished property. Here’s how it unfolds with the qualified intermediary:

• Purchase Agreement: When you’re ready to buy the replacement property, you’ll enter into a purchase agreement. This contract is typically between you (the buyer) and the seller of the replacement property. In a 1031 exchange, the purchase agreement names the QI as the buyer. Another option is to amend the purchase agreement to acknowledge the QI’s role in the transaction.

• Direct the QI to Transfer Funds: With the purchase agreement in place, you’ll instruct your QI to transfer the funds from the sale of your first property directly to the closing agent. This might be a title company, an escrow agent, or an attorney, depending on local practices. The funds cover the purchase price of the replacement property, along with any related closing costs.

• Closing the Deal: At closing, you’ll sign all the documents, including any that transfer the replacement property’s title from the seller to you. Because of the 1031 exchange rules, the QI technically “buys” the property on your behalf. Once you complete the closing process, you then receive the transfer of the property’s title, making you the official owner.

• Completing the Exchange: After closing, the QI provides a final accounting of the funds used for the new property purchase to you and your tax advisor. This documentation is key for your records and for reporting the exchange on your tax return.

Step 7: Report the Exchange to the IRS

Now that you’ve completed the 1031 exchange, the next step is to provide the information to the IRS so you can defer capital gains tax. Use Form 8824, “Like-Kind Exchanges,” to report the details of your 1031 exchange to the IRS with your annual tax return.

Documentation: Before you start filling out the form, make sure you have all the documentation. Your QI should provide you with a statement that includes details of the relinquished property. It includes property details, the dates of transactions, fair market values, and any money or property received in the exchange.

Form 8824: Form 8824 has several sections. You’ll list the descriptions of the properties exchanged. And you’ll include the dates of acquisition and transfer. Finally, disclose any relationship between the parties involved.

Calculate your basis in the relinquished property, the basis of the replacement property, and the realized gain or loss. The form also asks whether your exchange was a part of a larger transaction, which could influence how you report it.

• Report Each Property Individually: If you have multiple properties report each one separately. This can get complicated, especially with partial exchanges. It’s often wise to consult a tax professional familiar with 1031 exchanges.

• File With Your Tax Return: Attach Form 8824 to your federal income tax return for the tax year in which the exchange occurred. If you have a state income tax obligation, check if your state requires a similar reporting process. Some states have their own forms, while others simply require a copy of Form 8824.

• Keep Records for Future Transactions: It’s key to keep detailed records of your 1031 exchange for as long as you own the replacement property. You’ll use this information for calculating depreciation, and reporting any future exchanges. If you decide to sell in the future outside of the 1031 exchange process, this determines the basis of the property for tax liability.

Step 8: Reinvestment and Deferred Tax

To make sure you dodge capital gains taxes with a 1031 exchange, apply all the funds from the sale of your old investment property into buying the new one. This isn’t just about the cash you pocketed. Let’s say you had a mortgage on the old property; the new property should carry a similar or bigger mortgage. This is required to avoid taxes on any financial “breaks” you might get.

If you end up with cash in your hand or a lighter mortgage, the IRS will want a piece of that as taxes. And if you don’t go all-in with your investment or the new property is a bit cheaper, you’ll only partially escape the tax man. Keeping detailed paperwork is key here so you can show the IRS exactly how you rolled over every dime into your new investment. This is how to keep those tax benefits maxed out.

Be sure to follow all of the rules and timelines of the 1031 exchange process. Mistakes can lead to the disqualification of the exchange, resulting in immediate tax liabilities. Always work with knowledgeable professionals throughout this process.

Choosing a Qualified Intermediary

How do you find a QI that you can trust? Remember that they will be holding all of your money from the relinquished property sale. Here’s how you can go about finding a QI:

• Start with Recommendations: Chat with your network—real estate agents, attorneys, or accountants. Ask anyone you know who’s been through a 1031 exchange. Personal recommendations are gold because they come with firsthand experience of working with a QI.

  In all of my 1031 exchange transactions, I work with a QI that my broker recommends.

• Professional Associations: Look up professional associations related to 1031 exchanges. An example is the Federation of Exchange Accommodators (FEA). They often have directories of their members, which can be a great place to find reputable QIs.

• Check Experience: Once you’ve got some names, check their experience. How long have they been doing 1031 exchanges? Do they specialize in certain types of properties? Experience matters because the more transactions they’ve handled, the smoother yours is likely to go.

• Verify Credentials and Insurance: Make sure your QI is properly licensed and insured. At the very least, they should have errors and omissions insurance to protect you in case something goes wrong.

• Consult with Your Financial Team: If you have an accountant, lawyer, or financial planner, bring them into the conversation. They can help vet the QI and make sure they’re the right fit for your specific situation.

• Interview Potential QIs: Before you make your choice, have a chat with potential QIs. Ask about their processes, fees, and how they handle funds. Their answers will give you a sense of their professionalism and whether you’d feel comfortable working with them.

• Security of Funds: This is so critical. Ask how they safeguard your funds during the exchange. You want a QI that uses segregated accounts for each client to minimize risks.

• Customer Service: You want someone who’s responsive and communicates clearly. The last thing you need during a 1031 exchange is to chase down your QI for updates.

Alternatives to a 1031 Exchange

Let’s say you can’t identify replacement property that meets your needs. Don’t panic. There’s a couple of ways you can still defer capital gains taxes.

Delaware Statutory Trust (DST)

A DST allows real estate investors to turn their gains into a share of a trust that owns real estate. It’s similar to a real estate syndication, and the property can be anything from an apartment complex to a shopping mall. The DST qualifies as a like-kind property for 1031 exchanges and is a great way to defer taxes when you can’t find a suitable replacement property.

But investing in a DST isn’t for everyone. You typically need to be an accredited investor– which means you have a net worth of over $1 million (not counting the value of your primary residence) or have consistently earned a significant income.

Deferred Sales Trust

A Deferred Sales Trust is a way to instead of directly reinvesting sale proceeds into real estate your money goes into a trust. This trust then pays you over time, spreading out your tax bill.

When you place your money into the trust, it doesn’t just sit idle. The trust can invest those funds in various assets beyond real estate, such as stocks and bonds.

Wrap Up And My Experience With 1031 Exchanges

Understanding 1031 exchanges can offer real estate investors a powerful way to defer capital gains taxes. By following the specific rules, you can maximize your investment potential. This strategy is a smart move for anyone looking to leverage real estate investments more effectively.

In my own real estate investing journey, a 1031 exchange has been an incredible tool for growth. Starting with a 4-plex, I leveraged exchanges to move into increasingly larger investments. This included a 7-plex to a 28-unit apartment building, then to a 50-unit building, and eventually an 81-room hotel, all within a decade.

This progression using a 1031 exchange laid the foundation for my next steps as a hotel syndicator. 🏩And here’s the kicker: if I can do it, so can you. With the right knowledge and strategy, 1031 Exchange options can be massively impactful for all real estate investors.

1031 Exchange For Dummies: FAQ

Why should you not do a 1031 exchange?

You might choose not to do a 1031 exchange if you want to cash out. Or, you might pay capital gains taxes if you no longer want to invest in real estate. Or, if you find the rules and timelines too restrictive or cumbersome for your situation.

How soon after a 1031 exchange can you sell?

There’s no mandated minimum time you must hold a property after a 1031 exchange. But a holding period of at least 1-2 years is generally recommended to avoid scrutiny.

Can I still do a 1031 exchange in 2024?

Yes, you can still do a 1031 exchange in 2024. It allows you to defer capital gains taxes when selling an investment property. buying a new property of equal or greater value. This is a powerful tool in real estate investing to build wealth.