1031 Exchanges, How do they work?

Question

I'm familiar with the concept of exchanging a property for one of greater value to delay taxes. But, how exactly does the process work? And who is involved in the exchange?

Bill Exeter · Answer

Hi Mark,

You can structure a simultaneous 1031 Exchange without a professional Qualified Intermediary.  The two party "swap" is the easiest because two parties essentially swap properties with each other.  The more common three plus party concurrent exchange is more challenging and generally a part in the transaction serves as the "unofficial" Qualified Intermediary.  There are numerous ways to set it up, but as Dave pointed out, there are also numerous ways to slip up and have a disqualified exchange, so you have to be very careful with the way you structure a concurrent/simultaneous 1031 Exchange if you are not going to use a professional Qualified Intermediary.

Dave Foster · Answer

@Mike Parkins, for you the process is nothing different from the normal sell - buy of a piece of  investment real estate.  You use all the regular professionals - title co. realtor, etc as normal. The difference is you must use a qualified intermediary who interfaces with the closing entities on both the sale and purchase.  We document the exchange correctly and direct the funds between the sale and purchase.  The QI presence is imperative.  You must have that independent 3rd party in place prior to the sale and you cannot have actual or constructive control of the proceeds.

From the day you sell you have 45 days to identify in writing your list of potential replacements.  You have 180 days to complete the process.

The tax payer for the old and new property must be the same.  And in order to defer all tax you must purchase at least as much as your net sale.  And you must use all of the proceeds in the next purchase.

Of course within these 6 requirements there are all kinds of little quirks and nuance that your QI guides you through.  But at the end of the day you pay no tax or depreciation recapture on the gain.  You get to use all of that money to buy more investment real estate.  And there is an end game where you have several options to never pay the tax and actually eliminate it after deferring it for years.

Aaron Morris · Answer

Please, please listen to this advice and use a legitimate professional QI, not some attorney or anyone else. I have seen multiple investors end up paying taxes because the investor tried to get cheap and their cheap QI screwed something up. A good QI can do all kinds of things to defer the taxes: reverse exchange, exchanging in to development deals, etc. Once you decide on a solid QI take their advice. This is the IRS and there isn't wiggle room. Be diligent when identifying properties as well. You really only can ID 3, otherwise there's a new set of rules you have to abide by.

Dave Foster · Answer

@Mark Creason, Technically not but there're a lot of ways to inadvertently mess up the process and the wrong signature on a settlement statement can tank the whole deal.  So using a QI even in a simultaneous or direct swap is a pretty good plan.

Mark Creason · Answer

Would you need a QI if the 1031 exchange was completed simultaneously?

Mark

Dave Foster · Answer

@Kory Thaut, the 1031 will begin with the sale of the old property.  It's an awesome thing if you can get a contract on your new property contingent on the sale of your old property.  The order of contract doesn't matter.  You must only close the sale before you close the purchase.  So the best time to involve your QI officially is when you have a contract to sell your old property and the contract goes to the escrow company for closing.

In order to defer all tax you must purchase at least as much as your net sale (400K if that is net of closing costs) and use all of the proceeds in the next purchase (the net sale minus mortgage pay off). If you don't do that then whatever you buy down or whatever cash you take out is taxed as boot.  In your example you're buying down by $25K so you would pay tax on that amount but would shelter the remaining $125K of gain.  So not a bad day's work at all.

Kory Thaut · Answer

@Dave Foster For off market deals, would the order of operation be:

• Mail (or other) campaign to identify potential replacement properties
• Higher QI before making over hand having under contract OR Can the hiring of a QI wait until after the property is under contract, contingent on the sale of the old property?

On the net sale comment above as an example, could I sell a $400k property and buy a $375k property if my actual gains are only say, $150k after realtor fees, mortgage payoff, etc...?

1031 Exchanges, How do they work?

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