The IRS strictly limits how much time you have. It dictates your order of operations. And you need to be able to prove that your 1031 exchange process follows the rules.
In short, timing is important.
We take your 1031 exchange process very seriously. It has to be detailed, efficient, and safe. When you solve these, the exchange is actually quite relaxing and enjoyable.
Table of Contents
What is our typical 1031 exchange process?
The steps laid out below really matter. Of course there is the compliance aspect — the IRS and Treasury department expect you (and us) to follow their rules before you can defer taxes.
But we also set these up for your piece of mind. There should be communication and trust in every exchange process.
*Editor’s note: Even if you’ve been through plenty of 1031 exchanges before, we don’t want to assume anything or risk missing important details. The information-gathering phase is very important and should not be rushed.
Step 1.) Set up your exchange before closing on the relinquished property
At least 7 days before closing, let us know about your upcoming exchange. If needed, we are able to accommodate quicker turnarounds. We’ve set up a new exchange in as little as 30 minutes before closing; it is not ideal, but it is possible.
Here’s what we need to get started.
a. Your contact information
b. Brief run through on the numbers for your deal
c. The address of your relinquished property
d. Contact information for title closer/attorney handling the sale
We draft a 1031 exchange agreement for you to sign. (This exchange agreement is required by the IRS.) This document explains the rights and obligations of each party necessary to comply with the regulations.
Step 2.) We set up a new, secure account for your funds
We also open a new escrow account for only your funds (no commingling) at an FDIC-insured bank. No money enters or leaves the 1031 account without your verified signature and verbal authorization.
Wire fraud is a huge problem. Worse yet, the real estate industry is a prime target for fraudsters due to deal size. We constantly negotiate better account security with our banking and closing partners.
Step 3.) Close on your relinquished property
We coach the closer so that the transaction satisfies IRS regulations. Then, via secure wire transfer, the closing agent sends the proceeds from your sale directly to your new 1031 account. Funds will sit here until used when you close on your replacement property.
Step 4.) The identification stage
You have 45 days to identify replacement property(ies). You have 180 days to close on that property(ies). These deadlines are fixed and (virtually) impossible to change.
Identification must be unambiguous. It should not be possible to confuse two separate assets based on your description. Physical addresses are best, but other specific descriptions can work (i.e. “Mile High Stadium”).
What happens if you don’t (or can’t) identify anything? You’ll get your funds back after the end of the 45th day.
You are limited to identifying 3 replacement properties at any one time. (It is possible to identify more, but the rules change substantially. Speak with our office for more details.)
*Identification does not require that you make an offer or go under contract. In fact, the asset doesn’t even have to be for sale. You just need to list it unambiguously and get the list to us. We will provide you an editable online form for your ID.
Step 5.) Before you close on your replacement property
Once you find a replacement property and schedule a closing, provide us the following:
a. The address of your replacement property
b. Contact information for title closer/attorney handling the purchase
So just like your relinquished closing, we need to prep this closing to follow 1031 protocol. You’ll also authorize us to direct the bank to wire your 1031x funds to the closing table.
Step 6.) Close and finish your 1031x
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.)
Our office maintains a record of the documents you might need when you file your taxes. A 1031 exchange gets recorded using Form 8824.
To perform a 1031x, you must
- Relinquish (sell) investment property, and
- Replace it (buy) other “like-kind” investment property.
- You must exchange real property for other real property. Both must be held for investment or business use.
- 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 (net sales price) and equity.
For more details, see 1031 Exchange Rules and Regulations.
Sample questions from clients about like-kind 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 sometimes perform 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.