Understanding 1031 Exchanges: Six Crucial Steps for Success
From Deadlines to Replacement Properties: What You Need to Know
1031 Exchanges have long been a popular tool that savvy commercial real estate investors have used to “kick the can down the road” and defer capital gains taxes on the sale of a property. The potential savings can be huge. Yet this tax strategy can be tricky to navigate, and any mistake along the way can result in a failed exchange and a big tax bill. If you’re considering a 1031 Exchange, you can follow a few basic steps to help get your deal across the finish line – and end up with a new investment property that you won’t regret.
What is a 1031 Exchange?
A 1031 Exchange, aka a “like-kind” exchange refers to Section 1031 of the Internal Revenue Code. The tax code allows a property owner to sell one investment property and defer the capital gains taxes on the sale of the property by rolling the proceeds into a new qualifying property. The intent behind the tax law was to spur the buying and selling of real estate, which it does by contributing to up to 40% - 50% of all real estate transactions for retail investors. At the macro-level, 1031 Exchanges are huge contributors to economic activities generating 568,000 jobs, $27.5 billion of labor income and $55.3 billion to U.S. GDP.
How does it work?
The ability to defer capital gains taxes and reinvest profits into a new property sounds a little too good to be true. This is a proven tax strategy that has been in place for nearly 100 years. However, the process can be complicated, and the IRS is not forgiving when it comes to mistakes or omissions. Investors have to make sure all of the I’s are dotted and T’s crossed in order to successfully execute an exchange. Any one misstep could derail a 1031 Exchange. We have outlined six steps to consider before you sell a property so that you can hit the ground running in a 1031 Exchange.
Step 1: Know your deadlines
The IRS has very firm deadlines in which to complete a 1031 Exchange. From the day the sale of the original property closes, an investor has 45 days to identify, document and submit a list of qualifying replacement properties. The investor has a total of 180 days (including the 45-day identification period) to close on the purchase of their replacement property or properties.
Step 2: Assemble your “A Team”
There are many nuances and moving parts to any commercial real estate transaction, and a 1031 Exchange only adds to the complexity. It is important to work with a team of experts that can help look out for your interests and provide sound guidance throughout the process from start to finish. In particular, it is wise to consult with an accountant or CPA to discuss how a 1031 Exchange might fit your unique tax situation. In addition, no one wants to rush into a “bad” real estate deal simply to reduce their tax bill. So, it also is essential to work with an experienced broker who can help identify properties, spearhead deal negotiation and navigate the transaction complexities through closing.
Step 3: Select A Qualified Intermediary
Once a property sells, the IRS requires that funds must be held by a Qualified Intermediary (QI). A QI is a third-party entity that holds exchange proceeds, usually in a reserve account that preserves principle and earns interest at the current market rate. The QI also creates documentation supporting a taxpayer’s intent to initiate a 1031 exchange.
Step 4: Start Thinking About Replacement Options
1031 Exchanges require a seller to reinvestment proceeds into a qualifying “like-kind” asset. The IRS offers plenty of room to maneuver here. A replacement property doesn’t have to be an exact match. For example, an investor that sells a duplex doesn’t have to buy another duplex. Instead, an investor simply has to identify another investment property, such as a NNN medical office building, restaurant or dollar store. The key is the dollar amount. All of the money gained from the sale has to be reinvested in one or more properties to defer capital gain taxes. In some cases, investors may even put in extra cash to buy a higher priced property than what they are selling. Given the timing allowed to complete a 1031 Exchange, it is wise to start exploring viable replacement properties well before closing on the sale of the relinquished property.
Step 5: Identify & Document Replacement Properties
An investor needs to clearly document potential replacement properties within the allowed 45-day timeframe. It is important to understand that once the 45-day period ends, investors are not allowed to make any changes or substitutions to the replacement properties they have identified and submitted on their 45-day form. There are different ways to identify properties. Two of the most common are:
200% Rule: Exchangers can identify any number of properties as long as the gross price does not exceed 200% of the fair market value of the relinquished property (twice the sale price).
3 Property Rule: Exchangers can identify up to three properties that total any dollar amount and investors can acquire one, two, or all three of these identified properties.
Step 6: Negotiate And Complete Your Purchase
Leverage the expertise of your broker to negotiate favorable terms and complete the purchase of your replacement property or properties within the 180-day timeline. Again, it is important for your A Team to collaborate to close on your replacement properties, while simultaneously following the maze of protocols necessary to finalize your 1031 Exchange. Your CPA along with an experienced QI will help guide you smoothly through the process.
Many investors are looking to act now in order to get ahead of any potential tax law changes that may occur under the current administration that would limit the use of 1031 Exchanges. It is an ideal time to sell out of management-intensive properties and reinvest proceeds – tax free – into passive NNN assets that can generate steady, consistent income over the next 10, 15 years or longer. If you are interested in learning more about triple net lease assets and whether NNN aligns with your investment objectives and lifestyle goals, contact Andrew Vu at 415-539-1120 for a free, no-obligation NNN consultation.