What You Need to Know Before Your First 1031 Exchange

Conducting a 1031 exchange provides the opportunity to indefinitely defer federal income tax liability from a series of real estate transactions. However, there are several pitfalls of which investors need to be aware, as mistakes during the exchange process can both trigger unnecessary tax liability and lead to unnecessary risks. With this in mind, what do you need to know before conducting your first exchange? An experienced 1031 exchange facilitator explains:

1. You Must Purchase a Qualifying Replacement Property

To qualify for indefinite tax deferral under Section 1031, you must sell a piece of real estate in order to purchase a qualifying replacement property (or, in some cases, multiple replacement properties). While Section 1031 previously allowed like-kind exchanges involving both real and personal property, this changed with the enactment of the Tax Cuts and Jobs Act of 2017.

While the definition of “like-kind” real estate under Section 1031 is broad, there are limits. As a result, before you identify your next investment property, you will want to make sure it qualifies for a like-kind exchange.

2. You Will Want to Minimize “Boot” From Your 1031 Exchange

When you conduct a 1031 exchange, only the gains you reinvest in your replacement property qualify for indefinite tax deferral. Any gains that you hold onto or use for other purposes are classified as “boot,” and they are subject to immediate federal income taxation. As a result, in most cases, you will want to focus on minimizing the “boot” from your exchange.

There are a couple of ways to do so. One way is to ensure that all of the gain from the sale of your relinquished property goes into the purchase of your replacement property. Another way is to conduct an improvement exchange that allows you to invest in upgrades and additions in addition to investing in the replacement property itself.

3. You Must Comply with Strict Deadlines

Strict deadlines apply to like-kind exchanges under Section 1031. First, you must “identify” your replacement property within 45 days of selling your relinquished property. Second, you must purchase and take possession of your replacement property within 180 days of selling your relinquished property.

While this can be a fairly tight timeframe for performing your due diligence and closing on the acquisition of your replacement property, there are no exceptions. If you miss either of these deadlines, your exchange will not be eligible for like-kind exchange treatment under Section 1031. With this in mind, it will often make sense to start the process by identifying a replacement property, or you may want to work with a 1031 exchange facilitator to conduct a “reverse exchange,” which involves acquiring the replacement property first.

4. You Must Formally “Identify” the Replacement Property

As we just mentioned, the first deadline in the 1031 exchange process applies to “identifying” your replacement property. This involves more than just deciding what property you intend to purchase. To meet Section 1031’s identification requirement, you must formally identify the property in a signed document that you provide to your 1031 exchange facilitator or the current owner.

5. You Must Avoid Taking Possession of the Sale Proceeds for Your Relinquished Property

One of the key aspects of a 1031 exchange is that it is a true exchange of real estate—you sell your relinquished property in order to purchase your replacement property. While these transactions don’t have to take place simultaneously (although this is an option), you cannot take possession of the sale proceeds for your relinquished property if you close on your sale first. If you do, all of the gains from the sale will become immediately taxable.

To avoid taking possession of the sale proceeds for your relinquished property, you will need to work with a 1031 exchange facilitator. Your 1031 exchange facilitator will be able to hold the sale proceeds for you in escrow until the closing date for your replacement property arrives. Your 1031 exchange facilitator can also help ensure that you have all of the documentation you need to demonstrate compliance to the IRS—so that you are fully prepared to withstand scrutiny of your federal returns if necessary.

Schedule a Free Consultation with a 1031 Exchange Facilitator Today

Are you preparing to conduct your first 1031 exchange? If so, we can help, and we encourage you to contact us for more information. To schedule a free consultation with an experienced 1031 exchange facilitator, give us a call at 888-872-1031 or request an appointment online today.