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The 1031 Exchange Process Explained

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If you’re an astute real estate investor, you recognize the significant impact of capital gains taxes when owning investment real estate. However, there exists a strategic maneuver that could potentially be your golden ticket to amplified success – the 1031 exchange.

This intricate choreography of 1031 property exchanges, often referred to as “swap till you drop” can offer investors a path to defer all capital gains and depreciation recapture taxes.  In this comprehensive article, we will touch on many important topics surrounding the 1031 exchange process including:

  • Step 1: 1031 Exchange Language
  • Step 2: Engaging a Qualified Intermediary (QI)
  • Step 3: 45-Day Identification Window
  • Step 4: 180-Day Close Window
  • Step 5: Pre-Close
  • Step 6: Closing the Replacement Property
  • 1031 Exchange Process FAQs
  • Conclusion

 

Step 1: Include 1031 Exchange Language into Sales Contract

Prior to closing on your property, hereafter referred to as the “Relinquished Property,” there’s some groundwork to be laid.  One very important key to a 1031 exchange is to include 1031 exchange language into the sales contract prior to the close of escrow.  This 1031 language gives the title company a notice of assignment directive to wire funds directly to a Qualified Intermediary (QI) who will be handling the exchange.

Remember, to defer capital gains and depreciation recapture taxes upon the sale of real property, the taxpayer must avoid both actual receipt and constructive receipt of the final sales proceeds. If an investor were to take receipt of the proceeds from the sale of a property, the exchange would then be null and void and subject to full taxation.

Here is an example of what typical 1031 exchange language looks like within a purchase and sales agreement contract:

“Buyer is aware that seller intends to perform an IRC Section 1031 tax-deferred exchange. Seller requests buyer’s cooperation in such an exchange and agrees to hold buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to a qualified intermediary by the seller.”

 

Step 2: Engaging a Qualified Intermediary (QI)

A Qualified Intermediary (QI), also known as the exchange accommodator or exchange facilitator is an independent entity that enters into a written agreement to complete exchange transactions on behalf of the investors for the purpose of adhering to IRS 1031 exchange requirements.  In other words, when an investor decides to sell a property and utilize a 1031 exchange, an intermediary must be hired to take physical control of the sale proceeds and hold them in a 1031 escrow account.

The QI ensures the investor does not take physical control of the proceeds and the exchanger can stay in compliance with the IRC tax laws that govern section 1031 of the IRS tax code.

Once you have identified a suitable Qualified Intermediary (QI) to work with, let the documentation process commence.  At this time, prior to closing the sale of the Relinquished Property, you and your chosen QI will engage in an Exchange Agreement which requires the QI to:

  1. Obtain the Relinquished Property from the Exchanger and convey it to the buyer (via a direct deed from the Exchanger to the buyer), and
  2. Procure the Replacement Property from the seller and transfer it to the Exchanger (through a direct deed from the seller to the Exchanger).

Remember, to defer capital gains and depreciation recapture taxes upon the sale of real property, the taxpayer must avoid both actual receipt and constructive receipt of the final sales proceeds.  A Qualified Intermediary (QI) must be assigned to take physical receipt of the proceeds.  If an investor were to take receipt of the proceeds from the sale of a property, the exchange would then be null and void and subject to full taxation.

Read What Is a Qualified Intermediary (QI) to learn more.

 

Step 3: 45-Day Identification Window

Once the sale of your property is complete, the 45-day identification period begins. This period is relatively short and has a strict timeline that will prevent you from completing a successful exchange if not met.

The rules state, an exchanger has 45-days after the sale of their property to identify a suitable replacement property (or properties) that qualify under the like-kind requirement.  This identification must meet specific criteria: it must be precise, clear, in writing, bear the Exchanger’s signature, and be delivered directly to the Qualified Intermediary.

Once this 45-day period passes, the list of identified potential Replacement Properties cannot be altered; the Exchanger can only proceed to acquire properties from the list of identified options.

This 45-day period starts the day after the sale closes and includes all calendar days, including weekends and holidays.  In cases where no property is identified, the exchange funds will be returned to the Exchanger after the 45th day.

Read 1031 Exchange Rules Explained to learn more about the identification methods.

 

Step 4: 180-Day Close Window

After identifying a suitable replacement property, the next important step is to complete a purchase. You have 180 days after the sale of your original property to close on a new one, so time is again of the essence in this stage. If it takes you the full 45 days to identify a suitable property during the identification period, you will have 135 days left to close.

 

Step 5: Pre-Close

Prior to closing the sale of the Replacement Property, the Exchanger must assign rights under the Replacement Property purchase contract to the Qualified Intermediary and provide notice of assignment to the seller.

 

Step 6: Closing the Replacement Property

As the curtains close on the sale of your Relinquished Property, a pivotal moment arrives. The Exchanger grants authorization to the Qualified Intermediary (QI) to release the funds to the seller or closing agent for the acquisition of the Replacement Property.  Subsequently, the seller transfers the title directly to the Exchanger, thereby concluding the exchange.

The acquisition of the Replacement Property must be finalized by either the 180th day following the sale of the initial Relinquished Property or the due date of the Exchanger’s tax return (including extensions), whichever date comes earlier. Any remaining exchange funds will be returned to the Exchanger when the exchange is terminated.  A DST property can be a viable option for leftover “boot” funds in a 1031 exchange as investment minimums typically average $100,000.

After the closing is complete, not only will you now be the owner of a new property and have successfully completed your 1031 exchange, but you will have deferred some or all the capital gains tax you normally would have been responsible for paying.

Read What is a 1031 Exchange? and How a 1031 Exchange Can Potentially Benefit Your Real Estate Portfolio to learn more.

 

 

1031 Exchange Process FAQs

What is a 1031 exchange, and how does it work?

A 1031 exchange is a strategic process that allows real estate investors to defer capital gains taxes when selling a property and reinvesting the proceeds into a new property. The process involves partnering with a Qualified Intermediary (QI) to facilitate the transaction, ensuring compliance with IRS regulations.

 

Why is timing emphasized in the 1031 exchange process?

Timing is critical in a 1031 exchange due to strict deadlines. From identifying potential Replacement Properties within 45 days to completing the entire exchange within 180 days, adhering to these timelines is essential for a successful business.

 

Who is a Qualified Intermediary (QI), and what role do they play?

A Qualified Intermediary is a third party escrow company that facilitates the 1031 exchange process. They hold the exchange funds, assist with paperwork, and ensure all transactions comply with IRS regulations.

 

What is the Exchange Agreement, and why is it important?

The Exchange Agreement is a contractual arrangement between the investor and the Qualified Intermediary. It outlines the responsibilities of the QI in acquiring and transferring both the Relinquished Property and the Replacement Property, forming the foundation of the 1031 exchange.

 

Why is assigning rights under the sale contract necessary?

Assigning rights under the sale contract of the Relinquished Property to the QI gives them control over the transaction. This enables the QI to execute the exchange on your behalf smoothly, maintaining the integrity of the process.

 

What happens to the exchange funds during the process?

The net proceeds from the sale of the Relinquished Property referred to as exchange funds, are held by the QI in a separate escrow account. These funds remain safeguarded until they are utilized to purchase the Replacement Property.

 

What is the 45-day identification period, and why is it crucial?

Within 45 days of selling the Relinquished Property, the exchanger must identify potential Replacement Properties. This period demands specificity and clarity in your identifications, as changes after day 45 are not permitted.

 

Things to Note:

  • There are no extensions for the weekends or holidays that fall within your identification period.
  • 1031 exchange language must be written in the sales contract when selling your property outlining the QI which whom the funds will be sent to upon closing.
  • Exchangers must never take constructive receipt of the sales proceeds to qualify for a valid 1031 exchange.
  • Replacement properties that you are considering must be sent to your Qualified Intermediary (“QI”) and identified no later than midnight of the 45th calendar day
  • If 1031 exchange investors do not identify within the 45-day ID period, the 1031 exchange becomes disqualified.
  • Identified properties must be acquired within 180 days following the close of the relinquished property to qualify for a valid 1031 exchange.
  • following the close of your relinquished property sale transaction.
  • Only properties sent to the Q.I. for ID will qualify for 1031 exchange.
  • A Qualified Intermediary (QI) must provide a written and signed document that describes the properties you wish to identify including legal description, street address, or name of property or DST (if applicable).
  • If you wish to revoke a replacement property recently identified, you must provide a written and signed document that describes the property that you wish to remove from the list of identified properties.

 

Conclusion

We hope this article has given you an overview of important insights surrounding the 1031 exchange process.  Although a 1031 exchange can be more complicated than a traditional property purchase, the potential benefits may outweigh the extra effort required.

Though intricately woven, the 1031 exchange process holds immense potential tax advantages for real estate investors alike. The steps might appear elaborate, but their significance and potential rewards are worthwhile. When partnered with professional Qualified Intermediaries, you can navigate this journey, unlocking the potential to defer costly capital gains and depreciation taxes, propelling your real estate portfolio to new heights.

For investors who are challenged with the strict 45 and 180-day 1031 timelines, our Delaware Statutory Trusts (DST) properties can be a potential viable alternative.  DST properties are typically pre-financed and pre-closed, helping alleviate the strict 1031 timelines.  We also recommend identifying at least one DST property as a 1031 exchange backup in the event exchangers cannot find suitable replacement properties or need a fallback.  Browse our 1031 exchange approved properties today.

For a list of Qualified Intermediary (QI) partners, please contact us at info@exchange-x.com .

Be sure to visit our resources section to learn more about DSTs and 1031 exchanges.  For more information, schedule a consultation with an advisor or contact us today.

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Download your free copy of “The Power of 1031 Exchanges and Delaware Statutory Trusts (DSTs)” to learn more about how Delaware Statutory Trusts (DST) can complement your portfolio.