As with any first-time experience, it’s often helpful to have an idea of what to expect. The same holds true for 1031 exchanges. That’s why one of the first things we go over with new clients is how these transactions work. Most know the main benefit of doing a 1031 exchange—tax deferral. But how does a 1031 exchange work? What are the steps involved?
In this article, we’ve listed a simple, step-by-step guide into the mechanics of the most common type of 1031 exchange, sometimes referred to as a deferred, delayed, or Starker exchange. In total, we’ve broken the process down into 11 steps that are vital to the completion of the exchange and to the validity of the exchange in the eyes of the IRS.
These steps must be checked off; otherwise, you run the risk of invalidating your exchange, meaning you could wind up paying your capital gain taxes in full, plus interest and, occasionally, penalties. This is why it is recommended that you partner with a 1031 exchange expert who can ensure your transaction goes smoothly every step of the way.
How a 1031 Exchange Works: 11 Steps
Here are the 11 steps of a tax-deferred 1031 exchange.
1. The taxpayer obtains a sales contract for the relinquished property.
A deferred exchange involves the sale of the relinquished property first, followed by the subsequent acquisition of a suitable replacement property or properties. So before anything else can happen, the taxpayer must obtain a sales contract for the relinquished property.
2. The taxpayer signs an exchange agreement with the qualified intermediary (QI).
The next thing that must happen is the taxpayer enters into an exchange agreement with a QI. This comes straight from the treasury regulations. The exchange agreement establishes the taxpayer’s intent to do an exchange. It also creates contractual obligations between the QI and the taxpayer, and performs other functions necessary for the exchange to succeed, such as insulating the taxpayer from the proceeds.
3. The QI takes assignment to the sales contract.
The QI then temporarily assumes ownership of the sales contract to the relinquished property. This allows the taxpayer to directly deed the title to the buyer of the relinquished property.
4. The proceeds from the sale are placed into an exchange account.
Once the relinquished property has been sold to the buyer, the exchange proceeds are taken and deposited into a separate exchange account established by the QI. The QI holds the funds for the benefit of the taxpayer. The funds accrue interest in the exchange account. That interest is typically taken by the QI, but the taxpayer may have access to it following completion of the exchange.
5. The taxpayer directly deeds to the buyer of the relinquished property.
Because the QI takes assignment to the sales contract, the taxpayer is able to send the deed to the relinquished property directly to the buyer. Direct deeding is a reasonably new concept; previously, 1031 exchanges could be conducted by transferring the deed to the QI and then having the QI transfer the deed to the buyer. Direct deeding eliminates this hassle.
6. The taxpayer identifies replacement property after closing the relinquished property.
Once the exchange period begins, the taxpayer has 45 days to identify a suitable replacement property or multiple properties. The identification must be in written form, signed by the taxpayer, and must clearly describe the potential property or properties.
7. The taxpayer obtains a purchase contract for the replacement property.
After making a proper identification, the taxpayer then takes the steps necessary to acquire the replacement property. This involves obtaining a purchase contract.
8. The QI takes assignment to the purchase contract of the replacement property.
As with the sales contract, the QI takes assignment to the purchase contract so that the deed can be directly sent from the seller to the taxpayer.
9. The taxpayer closes on the replacement property by the deadline.
The taxpayer must formally close on the replacement property or properties prior to the end of the exchange period. This means that all replacement properties must be received before 180 days have passed, or before the due date for the taxpayer’s tax return unless an extension is filed. So, if the taxpayer originally sells the relinquished property in late December, they will only have until mid-April (assuming they sell as an individual) to complete the exchange unless they file for an extension.
10. The seller directly deeds the replacement property to the taxpayer.
This step follows the same process as step five, only with the replacement property, rather than the relinquished property.
11. The QI transfers proceeds to the seller and the remainder to the taxpayer.
The QI transfers the proceeds from the sale of the relinquished property to the seller of the replacement property. Then, if there are any remaining proceeds, they are sent back to the taxpayer and are taxed. Boot, whether in the form of cash or debt relief, is always taxable at the end of the transaction.
No matter how it’s looked at, tax-deferred 1031 exchanges are layered, complex financial transactions. Hopefully, this outline helps you understand the steps that go into a 1031 exchange. At CWS Capital Partners, we have decades of experience partnering with investors on their like-kind transactions and can work with you to ensure your exchange goes smoothly.
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