Intro to 1031 Exchanges

WHAT’S A 1031 EXCHANGE?

For more than 100 years, the tax laws of the United States have allowed investors to defer taxes on the gains generated by the sale of an investment property if the proceeds are properly re-invested in “like-kind” property.
 
This form of tax deferral is governed by Section 1031 of the Internal Revenue Code. It says: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind […]”.

Simply put, a 1031 exchange is the swap of one investment property for another likekind property without paying tax. A 1031 exchange transaction happens just like any normal real estate transaction, with two key differences:
 
  1. You must hire an independent 3rd party known as a Qualified Intermediary to facilitate your 1031 exchange.
  2. You may not take constructive receipt of your funds.
 
This graphic shows you the mechanics of a 1031 transaction. First, you will sign an agreement with a Qualified Intermediary (QI). When your relinquished property is sold, your QI will direct your proceeds to its partner bank. When it’s time to close on your replacement property, your QI will direct your funds from the bank to the seller of the replacement property, completing your 1031 exchange.

DON'T SELL… EXCHANGE!

Why would you explore a 1031 exchange? The better question is, why wouldn’t you?

1031 exchanges offer you the ability to defer – and even eliminate – your real estate taxes and maximize your real estate gains. They are a cheat code to building wealth.

It’s not just federal taxes that can be deferred – state taxes, investment income taxes, alternative minimum taxes, and depreciation recapture taxes may also be deferred. It’s like an interest-free loan from the US Government – one that may never require repayment.

The true power of a 1031 exchange is the ability to meet your investment objectives without losing equity to taxation. With more money, you can buy more property. Consider a scenario where you have $500,000 in equity in an investment property you are selling. The financial benefit of a 1031 exchange is enormous, allowing you to reinvest $325,000 more into your next property!
 

THE MAGIC OF 1031 EXCHANGES

As the previous graph shows, the financial benefit of a single 1031 exchange is enormous. Now let's look at what happens if you do multiple 1031 exchanges during your lifetime.
 

5 GUIDELINES OF 1031 EXCHANGES

To master the 1031 exchange code, you must know the rules. 90% of what you need to know can be distilled into these 5 Guidelines:

The property must be held for business or investment purposes

To defer all tax, you must purchase a property of equal or greater value than the net selling price of your relinquished property. 

Within 45 days following the close of your first transaction, you must identify, in writing, up to three possible replacement properties (you can identify more than three, but there are additional rules if you do). Only identified properties qualify for the exchange.

You have 180 days to complete both sides of your exchange (the buy and sell). This deadline is firm, regardless of whether the 180th day falls on a Saturday, Sunday or Holiday.

You must use a Qualified Intermediary to facilitate your 1031 exchange.

#1: It’s a Large Market With A Long History

#1: It’s a Large Market With A Long History

1031 exchanges account for an estimated 15% of all US commercial real estate transactions annually. That’s $185 billion worth of 1031 exchanges per year!
Not only is it a huge market, but it’s more than a century old. The 1031 exchange rules were created in 1921 following World War I.
#2: There Are 4 Types Of 1031 Exchanges

#2: There Are 4 Types Of 1031 Exchanges

There are 4 primary types of 1031 exchanges:
 
1. Forward Exchange: In a Forward Exchange, an investor sells a property first, then buys within 180 days.
2. Reverse Exchange: In a Reverse Exchange, an investor buys first, then sells within 180 days.
3. Simultaneous Exchange: A simultaneous buy-sell. These types of exchanges aren’t very common today.
4. Improvement Exchange – Forward or Reverse: In an Improvement Exchange, an investor invests in the acquired property – which can include repairs, improvements and / or new construction – using exchange equity. Improvement 1031 Exchanges are used in conjunction with either a Forward Exchange or a Reverse Exchange structure.
#3: You Can Do An Unlimited Number Of 1031 Exchanges

#3: You Can Do An Unlimited Number Of 1031 Exchanges

There is no limit to the number of times you can do 1031 exchanges. Many 1031 exchangers just keep exchanging. Why? Because if you keep rolling one 1031 exchange into another until your time on Earth is up, you will not only have deferred taxes on your gains each time, but you will have accomplished the seemingly impossible: avoiding taxes altogether. How is this? Because when your properties pass to your kin, they get a step-up in basis, effectively making a lifetime worth of gains invisible to the US Government.

This is known as the “swap ‘till you drop” strategy.

#4: There Are Nearly Infinite Exchange Options

#4: There Are Nearly Infinite Exchange Options

You can exchange raw land for a rental home, an apartment complex for a shopping center, or rental houses for an office building – there are more than 16 types of real estate that qualify for 1031 exchanges. And you can exchange any of these types of property inside any of the 384 Metropolitan Statistical Areas in the US. So long as all property is held for business or investment purposes, you have nearly infinite exchange options.

#5: You Don’t Need To Tell Anyone

#5: You Don’t Need To Tell Anyone

There is no provision in the 1031 rule book that states you have to publicly disclose that you're doing a 1031 exchange. You don't need to tell anyone you're exchanging other than your QI and your tax advisors. And you certainly don't have to advertise yourself as a 1031 buyer.

#6: Proper Planning Prevents Poor Performance

#6: Proper Planning Prevents Poor Performance

There are many ways to prepare for a 1031 exchange before the 45-day identification clock starts ticking. You can put your replacement property under contract first. You can enter into an option contract to buy your replacement property. Or you can have TEAM VIA create a shortlist of target replacement properties for you. Proper planning can minimize and even eliminate the time pressure of a 1031 exchange.

What is the role of a Qualified Intermediary?

A Qualified Intermediary has three primary duties:
 
  1. To provide consultation on your 1031 exchange.
  2. To secure your funds during the duration of the exchange.
  3. To prepare the necessary exchange documentation and coordinate with your closing agents to properly transfer the relinquished and replacement properties according to U.S. Treasury Reg. §1.1031(k)-1(g)(4).
 

Can I be my own Qualified Intermediary?

No, your Qualified Intermediary must be an independent third party, not a related party or agent. CPAs, attorneys, investment bankers, and real estate agents / brokers generally fall under the 'agent' category, excluding them from acting as your Qualified Intermediary. Additionally, any business or individual who is affiliated with an agent also cannot act as your Qualified Intermediary.
 
 

When do I need to hire a Qualified Intermediary?

Very Important: If you do not have a Qualified Intermediary in place before the close of your first transaction, the opportunity to do a 1031 exchange is lost.
 
 

Why does a Qualified Intermediary control my sale proceeds?

A key requirement of a successful 1031 exchange is that the investor selling the property must avoid constructive receipt of the proceeds from the sale. If you have the ability to access, control or receive, or could have received, the proceeds from your sale, the IRS will disqualify your 1031 exchange.

*Disclaimer: The information provided on this page is for informational purposes only and should not be construed as tax, legal, or financial planning advice. TEAM VIA does not provide tax, legal, or financial advice, and the content herein is not a substitute for consultation with a Qualified Intermediary (QI), tax advisor, accountant, financial planner, or other professional advisors. For specific guidance related to 1031 exchanges, including tax implications and financial planning, we strongly recommend consulting with a Qualified Intermediary and/or your tax and financial advisors. While TEAM VIA specializes in assisting with the sale or purchase of residential property, any matters related to tax planning or financial advice fall outside of our legal purview.

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As Co-Founders of TEAM VIA, Ben Toth and Chris Farber relentlessly advocate on behalf of their buyers and sellers. TEAM VIA is a solution-oriented group focused on sourcing, evaluating, and negotiating the best real estate opportunities — both on and off-market.

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