From: 1031 DST Solution
Date: December 1, 2020
How to Do A Successful 1031 Exchange
The IRS describes Internal Revenue Code Section 1031 as such:
“Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind 1031 exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.”
In short, Section 1031 of the Internal Revenue Code allows property owners to defer their capital gains tax by exchanging their property for “like-kind real estate” (also known as replacement property) with the proceeds from their sale. This strategy is a powerful tax deferment method that many successful investors in the United States utilize – but it is still quite tricky to navigate due to the many rules that must be followed.
101 Exchange – How to get started:
- Put your property on the market.
- Get a Qualified Intermediary (QI). You must do this before you close escrow.
- Begin your research on possible replacement properties and reach out to real estate brokers and, If you are considering DSTs (Delaware Statutory Trusts) and TICs (Tenants In Common), reach out to a specialist that exclusively focuses in this space to start looking at available opportunities.
- Close the sale. Once the sale is closed, your 45th day countdown begins. This means you have 45 days to identify what replacement properties you want to exchange into.
- On or before the 180th day, you must close on the identified replacement properties.
At this point you may be thinking to yourself, what’s so tricky about it? A bulleted to-do list makes it appear simple enough, but section 1031 further identifies the fine print under said list that must be followed.
- Acquire a good Qualified Intermediary (QI). A QI is the middleman between you and the sponsor, and they are the ones who hold your cash after they ‘sell’ your property and ‘buy’ the replacement property on your behalf. If the cash from your sale comes into your possession at any time during the process, your exchange is disqualified, and you would have to pay the full balance of your capital gains taxes. Ugh.
- Involve your QI prior to the sale of your relinquished property. You only have 45 days to identify your replacement property, and 180 days to close on the relinquished property, so the earlier you get your QI involved, the better! When your property is sold, the sum is sent to the QI and they hold on to the proceeds until they receive purchase instructions from you.
- To fully defer all taxes, your replacement properties mut have equal or greater purchase price, less deductible costs of sale. Further, your replacement properties must have equal or greater debt than the property you sold, to avoid debt relief (a.k.a. debt boot). If you find properties that are less than the values of the one you sold, you would be required to pay taxes for that remaining difference (also known as ‘boot’). Generally, the costs of sale as non-recurring closing costs can be deducted from the sales price but you’ll want to verify your specific situation with your tax advisor.
- The replacement property purchase must be in the same title as the relinquished property. The IRS will review the 1031 exchange section of your tax return to verify the selling entity and the buying entity are identical.
- The replacement property must be like-kind. This also means that the property that you exchange into must be held for investment purposes and expected to yield income or gain. For example, you could not purchase a home you plan to live in as a like-kind replacement.
- Have a Plan B, AND a Plan C. Not having reliable exchange backup options can be seriously detrimental to the success of your 1031 exchange. Many investors have had to wave goodbye to their 1031 tax deferral because the property they identified by the 45th day fell through. DSTs and TICs can serve as backup identification properties. You are allowed to identify a total of three properties for your exchange, and depending on the value of each and whether or not any fall through, you can purchase one, two, or all three as long as they all match the sum you received for the property you sold. Further, the 200% identification rule may grant you additional diversification by allowing you to identify more than three replacement properties as long as you do not exceed 200% of your relinquished property sales price.
1031 Exchanges can seem very complicated, but with the right team of your QI, broker, and sponsor, the exchange process can go smoothly. Contact 1031 DST Solution presented by Corcapa 1031 Advisors today to get started!
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