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What is a 1031 Exchange?

Updated: 7 days ago

A 1031 Exchange is a type of commercial real estate transaction where investors can defer capital gains tax on the profitable sale of an investment property - if the proceeds of the sale are reinvested in a new property that is like the one that has been sold.

The rules for completing a 1031 Exchange are defined by the Internal Revenue Service (IRS) and are described under article 1031 of the Internal Revenue Code (IRC).

The new owner must be like the property that was sold. Most business properties are like other business properties. For example, an investor could trade an office immovable for a small multi-family immovable. But they could not exchange a primary residence or a single-family holiday home for a shopping mall. Investors have an identification period of 45 days from the date of sale of the "transferred asset" to officially identify the new asset, they plan to buy, something called replacement property. They must purchase within 180 days of the date of sale. The debt and equity of the transferred asset at the time of sale must be equal to or greater than the debt and have it as a proxy asset. The owner of the title to the transferred property must be the same as the owner of the title to the estate. With these and other trading rules, transactions are very complex. Working from a checklist can help investors get out of this situation.

1031 Exchange Checklist

1031 Exchange checklist consists of eight steps. These are outlined below.

Item #1: Consult Tax and Legal Advisors

When reviewing a 1031 exchange, the first step is to consult with tax and legal advisors to make sure that this type of transaction is adapted to the needs of investors. For example, each investor has its risk tolerance, time horizon, return targets, and cash flow requirements. These differences mean that every investor has his or her own needs in a transaction. These needs should be discussed with a qualified CPA or tax counsel to determine whether a 1031 Exchange is appropriate.

Item #2: Find A Qualified Intermediary

A qualified intermediary, sometimes known as a foreigner, is an expert in 1031. Exchange rules are responsible for ensuring that the exchange of goods proceeds smoothly. Often, they may take title to the property once the sale is completed and keep the proceeds in receivership until the end of the exchange. Moreover, they advise their client to ensure that all the rules are respected. Thus, if a 1031 Exchange is appropriate for an investor, The next step is to identify and hire a qualified broker to facilitate the exchange process. In most cases, they can be found through an Internet search or with a referral from a co-worker or another investor. Because qualified intermediaries hold foreign exchange funds as fiduciary deposits, investors should ensure that prospective applicants have the financial strength to remain in business throughout the life of the grant.

Item #3: Prepare Exchange Documents

Once the qualified intermediary has been identified, the next point on the checklist is to work with the intermediary to prepare the necessary interchange documentation. They can vary slightly according to the type of exchange, but there are two key points. First, in the agreement to buy and sell the property for sale, a clause called the "exchange cooperation clause" should be added, therefore, all parties are on the same page as the seller intends to complete a 1031 Exchange. Secondly, the qualified intermediary must prepare all the documents required to convert the transaction into an exchange. This documentation must be completed before the sale of the assigned property and failure to do so may result in the transaction becoming taxable.

Item #4: Sell the Old Property

With the online qualified intermediary, the next element of the checklist is to sell the property. As simple as those sounds, there are a couple of steps here. The first is to select the property to sell. In many cases, an investor can have only one asset, so that decision is obvious. However, if an investor has several properties, he may need to take a moment to figure out which property to sell on the stock market. The second step involves hiring a real estate broker or agent to help commercialize the property. Although investors do not need to hire a broker, this is the standard process for selling a large commercial rental property. The broker has local connections and customers and provides good advice on selling price setting. Additionally, they will assist in negotiating the agreement and manage the logistics through closure.

Item #5: Identify Replacement Property

Once the assigned property is sold, a countdown begins to run from the closing date.

Consider the closing date as "day 0" and investors have until the end of the 45th day to officially identify a replacement property they plan to purchase. Some points about the alternative property. First, it must be something like what was sold. Again, most of the commercial merchandise looks like other commercial merchandise. Second, the market value of the replacement property must be equal to or greater than the value of the relinquished property. Thirdly, investors can designate a property that satisfies the market value test. Or they can identify up to three potential alternative properties, regardless of their value, if they approach at least one of them. Or they can identify as many alternative properties as they like if they do not exceed 200% of the value of the property transferred. Fourth, the substitute property must be officially identified in writing, usually with the address or legal description, with the qualified intermediary. Investors need to pay special attention to the clock because 45 days may go quickly and not correctly identify a replacement property within the required timeframe, and the transaction may become taxable.

Item #6: Enter a Purchase Contract

Once the replacement property has been identified, the next step in the checklist is to complete a purchase agreement for that property. This is a special place where qualified brokers and/or lawyers can be especially useful. As described above, they must ensure that the purchase agreement contains all the required language indicating that the seller intends to carry out a Bourse 1031. In addition, they must ensure that the expected completion date is 1031.

Item #7: Balance the Exchange

Investors must comply with several rules about the value of publicly traded properties. To ensure this is the case, the next element of the checklist is to balance the trade.

This can be achieved through:

Make sure that the replacement property is acquired for at least if the assigned property is sold. Take the entire proceeds from the sale of the transferred property and reinvest them all into the purchase of the replacement property. Ensure that the debt on the new property is equal to or greater than the debt on the transferred property. Make sure that no personal goods or cash products are received during the transaction. If they are, they are known as "boots" and are subject to taxation. This article is the place where the skilled broker earns his fees. It is their responsibility to guide the investor throughout the balancing process to ensure that there is no tax payable due to the exchange.

Item #8: Close on the Property

Of course, the last step is to shut down on buying the property. However, this is an important time. Investors are required to purchase the property no later than the end of the 180-day exchange period. In other words, they have an additional 135 days after the 45-day identification period for the purchase. The skilled intermediary also has a part to play in the conclusion. They shall ensure the transfer of title to the appropriate parties, withdraw the funds from the escrow, and ensure that they are distributed to the right parties with the right amounts. When the purchase of the replacement property is finished, the 1031 exchange is also finished.

1031 Exchanges & Private Equity Real Estate

From this checklist, a 1031 Exchange can be a complex transaction with tight deadlines.

However, the above checklist assumes that an individual investor is a person who sells and purchases the properties in question. That happens a lot, but not always. In some situations, it may make sense for an individual investor to partner with a sponsor corporation to purchase a replacement property. In such a scenario, the taxpayer may use the proceeds of its sales to purchase a fraction of commercial property through a tenant in a joint ownership structure. There are two major benefits to this approach. First, an investor can take advantage of the scale of a greater and more efficient property. Second, these properties are typically managed by a third party, meaning that they generate passive income. This makes it a good choice for investors who want to take advantage of the property, but not the worries of management.

Summary of 1031 Exchange Checklist

A 1031 Exchange is a commercial real estate transaction where investors can defer capital gains tax on the profitable sale of an investment property while the proceeds of the sale are reinvested or used for the purchase of a similar property. There is some complexity and tight deadlines at a 1031 Exchange so it may be useful for investors to work from a checklist.

The steps in the checklist include consultation with tax and legal counsel to determine eligibility, find a qualified intermediary, sell the property, find a replacement property, and purchase. The checklist presupposes that an investor sells and buys property on his or her initiative. For investors looking for passive income and a portion of a larger property, it can be an attractive option to work with a private equity firm.

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