Do you know how to do a 1031 exchange? This can be one of the most useful tax-deferral options for investors, but to make sure you reap the benefits, you need to follow a specific, step-by-step process.
How to Do a 1031 Exchange: A Step-by-Step Explanation
Note: We are not tax nor investment advisors and this article should not be taken as professional advice of any kind. The tax code is constantly changing, so speak with a qualified expert before making any decisions.
Step 1: Consider Professional Assistance
There’s no reason, at least from a legal and professional standpoint, why you can’t organize a 1031 exchange on your own. If you are a seasoned investor with multiple properties and a strong understanding of real estate and tax law, you can certainly complete the transaction on your own. (You will need an intermediary, however. See Step #2.)
But if you are not a qualified professional, it may be a good idea to hire outside help. An attorney or tax specialist can help you understand exactly what you need to do to complete the 1031 exchange while avoiding common mistakes.
Most people don’t have a detailed understanding on how to do a 1031 exchange, so we would generally recommend that you hire a professional.
Step 2: Find an Intermediary
In addition to the hired assistance, you’ll also need an intermediary. This is the person who handles the money from the sale of your previous home, money that will then be used on the next purchase. The money becomes taxable if you take it into possession, so it’s crucial that you don’t handle the money yourself. Handling the money would, in effect, disqualify you from the benefits of a 1031 exchange.
The intermediary will hold the proceeds from your property sale while you look for a new property. In most cases, the intermediary will be a representative from a bank or an attorney who can hold the proceeds.
Step 3: Sell Your Current Investment Property
Once you have professional guidance and an intermediary in place, it’s time to sell your current investment property. This is often referred to as the “relinquished property,” as you are relinquishing it for another investment.
This step largely proceeds like any real estate sale. You’ll contact your real estate agent (assuming you work with one) and tell them you’re ready to sell the property. They (or you) will go through the regular routine of listing and marketing the property, showing the property if needed, negotiating a sale, and drafting contract documents for the final transaction.
There is, however, one important difference. When conducting a 1031 exchange, the sale documents will have a special clause called the “Purchase and Sale Agreement.” This clause will have language that essentially describes your intentions to purchase a new property and complete a 1031 exchange. It will inform the buyer that you intend to complete a 1031 exchange, which is important since the buyer may have to sign documents that allow you to complete the 1031 exchange.
Step 4: Find and Identify Replacements within 45 Days
Now you have a ticking clock. From the day the relinquished property is sold, you have 45 days to identify replacement properties. There is little time to waste during this 45-day period, as you need to find potential replacements that would meet your investment needs and fit your budget.
Replacement properties need to be clearly described with written documentation. You’ll need a legal description of the property, a street address, and other information in the documents. You’ll also need the estimated value of the properties.
To get the benefits of a full 1031 exchange, you’ll have to purchase a property or properties that are equal to or more valuable than the relinquished property. Let’s suppose you sold an investment property for $800,000. To get the exchange, you’ll need to reinvest that entire $800,000. Conceivably, you could purchase another single property for $800,000 (or more) or you could purchase two properties for $400,000 each. As long as your reinvesting $800,000 or more, you’ll still be eligible.
Keep this in mind when searching for properties, as you may have to purchase more than one to get the full tax deferral.
Step 5: Close on a Replacement Property within 180 Days
Once you have replacement properties, the clock is still ticking. From time you sold your property, you have 180 days to close on the sale of a replacement property. So when you sold your property, two countdowns started rolling. The first (45 days) was for finding replacements; the second (180 days) is for finalizing the purchase.
Remember that these countdowns run at the same time. So if you identified replacements within 30 days, you now have 150 days remaining to close on the purchase.
In most cases, this is more than enough time. 180 days is roughly half a year; even in low-inventory situations, a dedicated property investor should be able to find quality properties within that timeframe.
During the purchase of your replacement property, you’ll direct the intermediary to use the funds for the purchase. This purchase should also include language that identifies the 1031 tax code. The seller will deed the property to you, the intermediary will release the funds, and you’ll have a new investment property.
But we’re not quite done yet…
Step 6: File Your Exchange with the IRS and Other Entities
Finally, you’ll need to file your 1031 exchange with the IRS, as well as state and local governments if required. For the IRS, you will use IRS Form 8824 to ensure you can defer tax payments on the purchase.
Not all states require it, but some want to know if you are doing a 1031 exchange. California, for example, has a reporting requirement, so you’ll have to complete an additional form to stay within the laws of California. This is another case where working with a professional will help, as they should be able to guide you through the various state and local requirements.
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