How Does 1031 Exchange Work – 1031 exchanges are a powerful tool for asset managers who want to offer their clients additional flexibility and options, or for investors who want to increase their earning potential.
And the most important part of that is the 1031 exchange process or the timeline that anyone who wants to do a 1031 exchange must follow.
How Does 1031 Exchange Work
So let’s dive into the timeline of the 1031 exchange, the key steps in that timeline, and important information to help you get through the 1031 process smoothly.
How To Make A 1031 Exchange Work
A 1031 or “similar” exchange, named under Section 1031 of the IRS Code, is a useful tool that asset managers and investors can use to defer capital gains taxes (among other useful benefits).
Here are the basic rules for handling a 1031 exchange on your or a client’s properties:
And, finally, it must follow the 1031 exchange timeline that this guide breaks down in detail.
Every 1031 exchange is reported to the IRS and must adhere to a specific time frame. The process includes two main deadlines: the first is written identification of the new property within 45 days, and the second is obtaining a replacement property within 180 days.
What Is A 1031 Exchange?
The specific type of exchange we break down below is often referred to as deferred or “delayed” exchange.
This is the most common, although we will break down other rarely used types of exchange later.
So let’s start with Day 1: selling the (soon to be) relinquished property that you’re giving away or “trading”.
As soon as you start working with a real estate agent and enter into a contract, it’s time to hire a qualified real estate agent.
Put Your 1031 Exchange Boot To Work
A qualified intermediary (or QI) officially begins the exchange period as soon as the ceded property is sold.
This is because there are a number of guidelines and rules that you need to be aware of, not only to ensure that there are no problems, but also to take full advantage of the exchange options available to you.
So now that the ceded property has been sold and the money is safely stored with your QI, the exchange process begins.
First, you have 45 days from the start of the exchange to select 3 exchange candidates.
What Is A 1031 Exchange And What Do You Need To Know In 2019?
By the end of the exchange period of 180 days of the contract, you will have to choose one of these properties to buy.
If you select 3 replacement candidates and then decide to buy a property that is not one of those candidates, the replacement is not valid and you will be subject to capital gains tax.
You must use one of these methods by the end of the 45-day period for the exchange to be valid or remain valid.
The remaining 180 days of the replacement period are reserved for completing the purchase of the replacement property.
Irs 1031 Exchange Rules For 2023: Everything You Need To Know
It’s important to reiterate that you must complete the purchase by the end of the 180-day period in order to comply with the 1031 exchange deadlines.
You’ve completed the exchange, deferred capital gains, and potentially helped yourself or your client benefit (more than just the tax savings) from switching your portfolio.
The investor’s annual tax in the year the surrendered property is sold should not be reported until the exchange is completed.
In some cases, an extension may be the best option, depending on when you complete the exchange.
Exchange Timeline: What You Need To Know [2023 Edition]
Consult with your tax professional during the 1031 exchange process to ensure you are taking the proper steps from start to finish.
So far, we’ve taken a deep dive into the details of the most popular type of 1031 exchange: the deferred or “deferred” exchange.
Each of these types of swaps is used less frequently than deferred swaps because they do not offer the same unique benefits.
In a simultaneous exchange, the property you are selling and the replacement property you are buying close on the same day.
Reverse 1031 Exchange: How Does It Work?
Reverse or forward exchange is easy to understand as it is almost the same process but in reverse.
Once the property is sold, the proceeds pass through your qualified intermediary’s trust or similar vehicle.
The last typical type of exchange, a construction or improvement exchange, is used for the purpose of improvement using capital from the sale of the relinquished property.
What changes is that by the 180th day, all improvements must be completed on the new replacement property before title can be transferred.
How Much Does A 1031 Exchange Cost? (updated For 2021)
Also, the rules state that you must get “substantially the same property” identified within 45 days of the exchange process.
That last part mostly refers to the fact that by the time you receive the property, it should have the same or greater value as when you originally selected it as a potential replacement.
If you’ve landed here, you’re probably already thinking about 1031 exchanges and want to know a little more about how they work.
Why would you want to use a 1031 exchange instead of just selling one property and buying another?
What Are The Steps Of A 1031 Exchange?
The primary benefit is the ability to defer capital gains taxes indefinitely, reason enough to consider a 1031 exchange a valuable tool for your clients.
Now that you understand how a 1031 exchange works, it’s time to consider whether it’s right for you or your clients.
Only you know your wants, needs and situation, so be sure to consider the whole picture before taking action.
Generally, there is only one additional cost associated with a 1031 exchange: hiring a qualified intermediary.
Partial 1031 Exchange
Hiring a qualified broker is essential for a reverse exchange and is practically required for any type of facilitated exchange.
In terms of risk, most types of exchanges—especially deferred exchanges—contain only one risk: paying capital gains because you don’t complete the exchange on the timeline.
If you’re hoping to avoid capital gains tax on the exchange, something happens during the deferred exchange process that delays the purchase past the 180 day mark…you’re on the hook.
With that said, the 180 day period is generous and more than enough time to complete the time jump, complexities included.
What Is A 1031 Exchange?
Whether you are a property manager or an investor, a 1031 exchange is a useful tool that makes many things easier.
It can be beneficial to use a qualified broker and consider finding an exchange specialist to help you through the process, whether you have a team or manage it yourself.
How to help manage your properties – simple and easy – including everything from accounting to handling service calls.
However you go, we hope this guide has helped shed some light on the 1031 timeline so you know what to expect the next time you or one of your investors needs an exchange.
How Does A 1031 Exchange Work? A Comprehensive Guide
If you want to learn more about how 1031 exchanges work, 1031 exchange rules, types of exchanges, and everything else you need to know, read our master guide here: IRS 1031 Exchange Rules: Requirements, Timeline, and Guidelines.
It offers a complete package of accounting tools that allow you to monitor, manage, receive and pay everything from one, practical dashboard:
The materials and information available on this website and in this article are for informational purposes only and are not intended to provide tax or legal advice. You should consult your attorney and/or accountant for advice regarding any particular issue, question or concern.
David is a co-founder and CMO, best-selling author, CLE legal speaker, and real estate investor. When he is not hanging out with his three children, he writes articles here! Or maybe you’re an experienced property manager or real estate investor who knows the ins and outs but is looking for information on unusual use cases like vacation homes.
What Qualifies For A 1031 Exchange?
In this guide, you’ll learn everything there is to know about 1031 exchanges and the IRS 1031 exchange rules.
A 1031 exchange, or “like-kind” exchange, is a method of exchanging investment properties that allows you to defer capital gains taxes.
Referred to as IRS Code Section 1031, the law was enacted in 1921 to encourage active reinvestment by giving investment property investors the ability to avoid ongoing real estate investment taxation.
With a 1031 exchange, you can defer taxes on investment properties you own or hold indefinitely until you sell, exchanging one property for another.
Eight Things Real Estate Investors Should Know About Section 1031 Exchange
This is especially useful when you consider what it allows you to do, and it opens up a whole host of additional benefits.
You can take some of your Class C real estate and trade it for a more stable Class A, which will help you weather the storm.
With a 1031 exchange, in the same way that stock investors shift investments from live stocks to the S&P, you’ll be able to shift your capital gains taxes in a way that lowers your risk.
You can also, similarly, switch some of your Class C or D properties to high maintenance Class A or B properties if the maintenance is too high.
How It Works
Or, you can move your property from one location to a more desirable or promising location in an effort to position your property for higher future income.
And the great thing is that there is no limit to how often or how much you can exchange
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