Real Estate Guide: How Does A 1031 Exchange Work?

Saying goodbye to a building, land, or business property is an important step for any business person. The taxes on profits from selling these types of properties can be overwhelming, but if you learn about Section 1031 of the Internal Revenue Code, you will be able to save some money that you can re-invest later on which will help your business grow. In this article, we’ll take a look at the 1031 exchange, also known as a like kind exchange.

Understanding the Process of 1031 Exchanges

So, exactly how does a 1031 exchange work? Who can use it? According to Section 1031 of the Internal Revenue Code, like-kind exchanges occur when you trade real property used for business or investment purposes exclusively for another investment property of a similar type or like-kind. This strategy has been around since the Internal Revenue Code amendment in 1921, following a congressional law allowing investors to avoid the taxation of ongoing property investments and promote active reinvestment. Typically, real estate investors engaging in like-kind exchanges are not necessary to show a gain or loss under the Internal Revenue Code. This rule applies unless they receive non-like-kind property or money or if the property was considered for sale rather than for business use.

●      Select the Property You Wish to Sell

A 1031 exchange is applicable only for investment or business properties. Personal-use properties, such as your primary residence or a vacation home, are generally ineligible. Begin by identifying the investment property you intend to sell—one that would incur a capital gains tax if sold outside of a 1031 exchange.

●      Select the Property You Wish to Buy

The property you sell and the property you purchase must be “like-kind,” meaning they share similar attributes or class, though they do not need to be of the same quality (details on this will follow). Remember that U.S. properties are not considered like-kind to properties outside the U.S.

●      Examine the Types of 1031 Exchanges

Real estate investors commonly utilize five types of 1031 exchanges:

●          Delayed Exchange: Sell a property and purchase a replacement property within the allowed timeframe.

●          Delayed Reverse Exchange: Purchase the replacement property before selling the current property.

●          Delayed/Simultaneous Exchange: Buy the replacement property simultaneously with the currently sold property.

●          Simultaneous Build-to-Suit Exchange: You may acquire built-to-suit belongings before selling your current property.

●          Delayed Build-to-Suit Exchange: Replace the current property with a newly constructed property tailored to the investor’s needs.

It is crucial to note that investors can only indirectly receive proceeds from the sale while identifying and purchasing a replacement property. In contrast, the money is kept in trust by a 1031 exchange middleperson,  called an accommodator, until the new property purchase is finalized.

●      Choose a Qualified Intermediary

A qualified intermediary, an exchange facilitator, must complete how a 1031 exchange works. This intermediary holds the proceeds from selling your original property and ensures they are used to buy the new property. Select an experienced and dependable intermediary, as they will manage crucial parts of the exchange.

The intermediary must not be a relative or anyone with whom you’ve had a formal relationship (such as an agent, broker, accountant, attorney, or employee) within two years before the exchange.

Conclusion

Hopefully, now you understand how a 1031 exchange works. Remember, the fundamental principle of a 1031 exchange is that if you do not receive any proceeds from the sale, there is no taxable income. Thus, taking possession of the cash or other proceeds before the exchange is finalized could invalidate the transaction and will increase your immediately taxable income. You will likely need to file IRS Form 8824 with your tax return. This form requires you to describe the properties, provide a timeline, identify the parties involved, and detail the financial aspects of the exchange.