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Understanding
Delayed 1031 Exchanges
With 1031 exchanges offering such compelling tax advantages, the kinds of exchanges that are possible have evolved over the years. Decades ago, when the Internal Revenue Code first authorized the exchanges, there was only one kind, and it was extremely limited. Now known as the simultaneous exchange, it required the sale of the appreciated property and the acquisition of the subsequent property to occur at the same time.
Eventually, the code was modified to permit exchanges that allowed for some time to elapse between the sale of one property and the acquisition of the replacement property. These delayed 1031 exchanges are now the most common type of exchange, and while they are relatively straightforward to structure and execute, they must be done in accordance with the IRS rules. Any failure to follow even a single part of the procedure will result in the loss of the benefits associated with 1031 exchanges, even if all the remaining rules are followed to the letter.
Savvy real estate investors are therefore keenly aware of the following key elements of a 1031 exchange:
Finally, the Internal Revenue Code of 1954 achieved its goal of consolidating the IRC provisions from 1939-1953, revising and renumbering the existing Code sections for overall ease of operations. In so doing, Section 112(b)(1) was reborn as Section 1031 of the Internal Revenue Code, laying the groundwork for the modern structure and functions of the exchanges that bear its name.
Subsequent evolutions of 1031 exchanges broadened their appeal and deepened their value to tax-averse investors seeking to capitalize on appreciated assets while minimizing tax liability.
1. The sale of the appreciated property, and the treatment of the proceeds
When the original property is sold, it is imperative that the investor does not receive the funds generated by the sale. Instead, they are sent directly from escrow to a pre-selected independent third party, known as the qualified intermediary (QI) or the 1031 exchange facilitator. These professionals know to place the funds in an independent, FDIC-insured account, taking care not to commingle these funds with those of any other investors. The funds remain in this account until they are needed to purchase the replacement property.
2. The selection of the replacement property
As soon as the proceeds from the original sale are placed with an intermediary, two important clocks start ticking: the 45-day window during which a replacement property (or properties) must be identified and the 180-day window during which the second transaction must be closed. In the initial 45 days, the investor must identify at least one property, or as many as the 200% rule allows, that will replace the relinquished property. Ideally, the property or properties in question will be equal to or greater in value than the relinquished property. (The investor can also choose a property of lesser value and commit additional funds to capital improvements; those funds will be counted towards the final net worth of the replacement property.)
Either way, the investor must identify the replacement property to the intermediary within 45 days of the closing of the first transaction; failure to do so invalidates the 1031 exchange. As far as replacement property ID rules, there are the 3-property rule, the 95% rule, and the 200% rule, which we discuss in more detail in our 1031 Exchange Masterclass taught by Daniel Goodwin.
3. Closing the deal on the replacement property
The investor has only 180 days to close the transaction for the replacement property. Accordingly, it’s usually considered best not to be overly communicative that the replacement property being sought is part of a 1031 exchange until a price is agreed upon; the owner of the replacement property would immediately understand that the investor is under a deadline, which translates into leverage for the seller and increased pressure for the buyer. Nevertheless, it is critical that not only the price be agreed upon, but also that the entire transaction be closed within 180 days of the sale of the relinquished property. As with the sale of the relinquished property, the purchase of the replacement property must be noted in the paperwork as part of a 1031 exchange.
The importance of the 45- and 180-day deadlines in a 1031 exchange cannot be overstated. The IRS is inflexible, offering adjustments to these timelines only in the event of a Presidentially declared disaster or state of emergency. Failure to complete the necessary steps within these windows, or improper processing of the 1031 exchange, may invalidate the entire exchange. Such an invalidation would subject the investor to significant taxes, possibly including treating the transaction as ordinary income rather than capital gains; ordinary income tax rates are significantly higher than capital gains tax rates, so the resulting penalty could be severe.
However, with a carefully constructed transaction and the efforts of a professional QI or exchange facilitator, a 1031 exchange can pay you handsome dividends and defer capital gains taxes for years and years to follow. Choosing a qualified intermediary is a critical step for the investor, as a capable, experienced QI will facilitate the transaction and ensure a seamless process.
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