Table of Contents
- What is the typical 1031 exchange process like?
- Qualification requirements
- Common questions from clients about commercial exchanges
What is the typical 1031 exchange process like?
What should you expect during your exchange? Here is a brief summary.
Step 1.) Share information
You provide us the following:
a. Your contact information
b. The address of your relinquished property
c. Contact information for title closer/attorney handling the sale
Step 2.) Make an agreement
We draft a 1031 exchange agreement for you to sign. (This exchange agreement is required by the IRS.) You return the signed exchange contract to us, and we review the settlement statement with your closer.
Step 3.) Open a secure account for your funds
We also open a new bank account for only your funds. This 1031 bank account requires your signature to open the account and to make any withdrawals from the account.
Step 4.) Close on your 1031 sale
Your coordinate coaches the transaction closer to satisfy IRS regulations. Then, the closing agent sends, via secure wire transfer, the proceeds of your investment property sale into your new 1031 account.
Step 5.) Find your next investment opportunity
You have 45 days to identify replacement property(ies) using a form that we provide. You have 180 days to close on that property(ies). These deadlines are fixed and virtually impossible to change.
Step 6.) Share again
You provide us the following:
a. The address of your replacement property
b. Contact information for title closer/attorney handling the purchase
Step 7.) Close on your 1031 purchase
We wire your money to the closing table for your replacement property. If there are any leftover funds in your 1031x escrow account, we will wire those to you and taxes may be due on this amount for that taxable year.
To perform a 1031x, you must
- relinquish (sell) investment property, and
- replace it (buy) other “like-kind” investment property.
- Generally, any real property is exchangeable with any other real property, regardless of use, so long as both are held for investment or business use.
- You must acquire your replacement property within 180 days.
- You cannot complete an exchange by yourself. Instead, the IRS requires that you use a Qualified Intermediary, such as 1031x.com, Inc.
- In order to fully defer capital gains tax, you must exchange equal or up in value and equity.
Sample questions from clients about 1031 exchanges
Here are a few common questions from past clients.
– Can I use proceeds to improve property?
Client A asks:
If we receive a total of $500K from the sale of a lake property (Profit $370K), and we intend to purchase a commercial building for $475K. Can we apply $25K of the lake property sale toward a new roof on the purchased property? Will we still defer all taxes related to the sale or do we have to choose a second piece of real estate to apply the remaining $25K?
Thank you for contacting us. The IRS considers improvements made to a property after purchasing it to be outside the 1031x (and therefore taxable). Your best option is to have the new roof put on prior to your purchase, if possible. Have the roofing company paid as a debit and reflected on the seller’s settlement statement. What you are really doing is raising the sale price to $100K and having the seller pay for the new roof. Does this work for you? If not, you may have to consider a construction 1031x to achieve the same result.
– What qualifies as “held for investment”?
Clients F and V ask:
We understand that we have to buy investment property with our 1031 money. But, how long do we have to hold that property for to keep it as a valid exchange? What happens if we decide to sell again within 6 months or a year?
Dear F and V,
There is no period of time for which you MUST hold a relinquished property. You may commonly read about a “1-year” rule, but that is a guideline rather than a hard regulation. Whether you held a property for investment or for immediate resale depends on all of the facts and circumstances. Whatever you can do to document your file to show that you meant to hold this new property for investment will help should the need arise.
The passage of time is only one of many factors that the IRS might consider. We have performed exchanges whereafter the taxpayer was in the midst of fixing up the property for rent and a buyer showed up in the first 60 days and purchased it. It was still a successful 1031 exchange! Imagine a circumstance where you 1031 exchange into a property; then, unexpectedly, the market starts dropping. Could the IRS reasonably force you to suffer year-long downturn in the market before you can get out of a property? Of course not.
– Investment property to principal residence?
Client C asks:
Can I convert a principal residence to investment property and then 1031 exchange? Or, alternatively, what if I exchanged into an investment property and then want to move in?
The rules here are strangely inconsistent.
If you convert a principal residence to investment property — and you lived in the property for 2 of the past 5 years — then the entire capital gain is exempt from taxation. This falls under IRC Section 121. But the depreciation recapture for the time used as investment remains taxable on sale.
Contrariwise, if you convert an investment property to principal residence — and live in the property for 2 of the past 5 years — then capital gain is allocated based on time used for each purpose. The pro rata share of gain for the time as principal residence is exempt under Section 121. The pro rata share of gain for the time used as investment will be taxable on sale. All depreciation recapture will be taxable regardless of use.
– Do I need a TIC agreement for community property?
Client G asks:
As you have advised my wife and I will be holding title as two single member LLC’s as tenants in common. My lender does not require a TIC agreement. Does the IRS require a TIC agreement? Is there anything else that I need to do to insure that the IRS will allow my 1031 exchange considering that my wife and I held title as community property in California and will now be holding title as tenants in common in Colorado?
No TIC agreement is required by us. Remember, the tenants in common structure carries with it many implicit rights. For instance:
- right to share possession,
- rights to share income,
- duty to protect the property,
- duty to share expenses,
- right to sell their share separately
Importantly, tenants in common do not share is this:
- If one owner wants to spend money on capital improvements and the other one does not, then the dissenting co-owner cannot be forced into making unwanted improvements.
All of this will probably be non-issues for you two. Finally selling as community property and buying as single member LLCs is exactly what we recommend.
To get answers about your specific tax exchange needs,
please contact us here.