A 1031 exchange offers the investor an option to reinvest proceeds from the sale of an investment property—also known as relinquished property—into a qualified placement property to defer capital gains tax. As a result, the exchange can use 100% of the proceeds—or equity—from the sale to purchase another property and defer the capital gains tax. However, the property involved in a 1031 exchange must be held for productive use in a trade or business, income production (like rentals), or investment purposes.
While the 1031 exchange is convenient for taxpayers, the practice can also be complicated and confusing. To help you do it right, here are the do’s and don’ts of setting up a 1031 exchange.
DO: Have a complete understanding of what a 1031 exchange is.
Having a thorough understanding of what exactly the 1031 exchange is, will help you carry one out without any hassle. It will allow you to exchange one piece of real estate for another, as well as defer capital gains taxes when you sell the first property.
DO: Know that a 1031 exchange does not solely cover real estate.
1031 exchanges actually encompass a variety of properties. The only properties that do not qualify are the following: inventory, stock in trade, stocks, bonds, and other types of notes, such as securities, debt, partnership interests, and trust certificates.
DO: Hire a qualified intermediary to handle your exchange proceeds.
In the event that you take possession (constructive receipt) of the proceeds from the sale of your property, it will forfeit your ability to carry out a 1031 exchange. Having a qualified intermediary, otherwise known as a company set up to handle the transfer and close of 1031 exchange funds, allows investors not to take a constructive receipt.
DO: Know you’ll likely defer an exchange.
You must understand that you need to identify and secure a like-kind property after selling. Investors typically identify up to three properties in case their first choice doesn’t pan out. At times, investors perform the exchange immediately upon sale, but this process is usually difficult. This implies that you’ll perform a deferred exchange. An intermediary party will hold the funds from your sale, and if you touch the proceeds from said sale before the exchange is complete, then you’ll end up paying taxes on them.
DO NOT: Attempt to exchange a personal property.
1031 exchanges are only applicable between investment properties that you own, which means REITs, funds, or an LLC that owns shares in another LLC do not qualify. As per the IRS, “Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.”
DO NOT: Stall the exchange.
You must keep in mind that time is of the essence when it comes to 1031 exchanges. You have 180 days from the escrow close to complete your purchase of a replacement property. When you exceed this time limit, you lose the benefits of the exchange.
With all that said, it’s important to note that individual tax situations vary. Sometimes, it can turn out to be extremely complex. You would want to consult a professional to advise you on the best course of action, such as PJL Investments.
We help clients with all things related to 1031 exchange, and are excellent at helping you reach your financial objectives. Get in touch with us today, to learn more!