Hey everyone, it’s Finance Fridays again. I’m actually back at my old stomping grounds in California for my friend’s wedding. However, I still want to try to keep up with my blog. As such, this will be a relatively short post about “What is a 1031 Exchange?”

Stock Photo from: Pixabay

What is a 1031 Exchange?

Well, first of all, let’s be clear. I’m talking about houses here. More specifically, the buying of a new house and selling of an old one. At first glance, this may not seem like a Finance Fridays kind of post, but it is for certain individuals.

Before I can really start talking about what it is, I need to provide a little bit more background on the buying and selling of a house, outside of my other posts.

Ok, what do I need to know?

Please note that this only applies to buying or selling a house that is an investment or business property. This does not apply for any house that is utilized as a residence.

I see, so what is the 1031 Exchange in reference to?

In general, when selling an investment or business property you need to pay capital gains tax (state and federal). This can be a significant amount, up to like 30% if you don’t use a 1031 Exchange.

So, in order to defer these taxes, you utilize a 1031 Exchange. Notice I said defer. Someone has to pay the taxes eventually.  Death, Taxes, and Student Loans, remember?

Ok, I see, so how does it work?

A 1031 Exchange (also known as a Starker Exchange) basically has a few things to know:

• Sold property must be “exchanged” for a like-kind property
• The exchange property must be
  • identified in 45 days
  • received in 180 days
• Exchange does not need to be simultaneous, however
  • one must use a “Qualified Intermediary”
• To obtain full tax benefit, new property must of equal or lesser value

What is a like-kind property?

This is in reference to the exchange of property for other things, such as a personal property, or promissory note. In other words, you have to sell your business/investment property and buy something which would also qualify as a business/investment property.

You can’t sell your apartment building and then buy a house with plans to use that as a residence.

Can I do a 1031 Exchange on my second home?

That depends.

Is your “second home” only used by you and bought by you solely for “appreciation”? Then no.

However, there are some bare minimums in order to consider your second home as an investment property:

For a minimum of two years prior to, and after the exchange:

• The property must be rented for a minimum of 2 weeks to a non-relative.
• You can rent to a relative if it is their primary residence at fair market value rent.
• The property must only be used personally for 2 weeks or 10% of the time rented.
• You can maintain the property for an unlimited amount of time, but documentation must be kept for these activities.
• The property should be placed on Schedule E of your tax return and reported as income property.

So yea, it has to be a legitimate income property and reported as such.

Does a “fix and flip” qualify?

In a word? No.

It hasn’t been “used” as no one has lived in it. It’s only been bought and held for sale while doing renovations and is not considered an business/investment property for the purposes of a 1031 exchange.

I see. So what are the steps then?

There are tons of guides online, but I like Wikipedia for its (relative) simplicity:

The following sequence represents the order of steps in a typical 1031 exchange:

Step 1. Retain the services of tax counsel or a Certified Public Accountant (CPA).

Step 2. Sell the property, including the Cooperation Clause in the sales agreement. “Buyer is aware that the seller’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with seller to accomplish same, at no additional cost or liability to buyer.” Make sure your escrow officer/closing agent contacts the Qualified Intermediary to order the exchange documents.

Step 3. Enter into a 1031 exchange agreement with the Qualified Intermediary, in which the Qualified Intermediary is named as principal in the sale of the relinquished property and the subsequent purchase of the replacement property. The 1031 Exchange Agreement must meet with Federal tax law requirements, especially pertaining to the proceeds. Along with the basic agreement document, an amendment to escrow document is signed which names the Qualified Intermediary as seller. Normally the deed is prepared for recording from the taxpayer to the true buyer. This is called direct deeding. It is not necessary to have the replacement property identified at this time.

Step 4. The relinquished escrow closes, and the closing statement reflects that the Qualified Intermediary was the seller, and the proceeds go to the Qualified Intermediary. The funds should be placed in a separate, completely segregated money market account to insure liquidity and safety. The closing date of the relinquished property escrow is Day Zero of the exchange, and that is when the exchange clock begins to tick. Written identification of the address of the replacement property must be sent within 45 days, and the identified replacement property must be acquired by the taxpayer within 180 days.

Step 5. The taxpayer sends written identification of the address or legal description of the replacement property to the Qualified Intermediary, on or before Day 45 of the exchange. The document must be signed by everyone who signed the exchange agreement. It may be faxed, hand delivered, or mailed either to the Qualified Intermediary, the seller of the replacement property or his agent, or to a totally unrelated attorney, preferably by certified mail, return receipt requested.

Step 6. Taxpayer enters into an agreement to purchase replacement property, again including the Cooperation Clause. “Seller is aware that the buyer’s intention is to complete a 1031 Exchange through this transaction and hereby agrees to cooperate with buyer to accomplish same, at no additional cost or liability to seller.” An amendment is signed naming the Qualified Intermediary as buyer, but again the deeding is from the true seller to the taxpayer.

Step 7. When conditions are satisfied and escrow is prepared to close and certainly prior to the 180th day, per the 1031 Exchange Agreement, the Qualified Intermediary forwards the exchange funds and gross proceeds to escrow, and the closing statement reflects the Qualified Intermediary as the buyer. A final accounting is sent by the Qualified Intermediary to the taxpayer, showing the funds coming in from one escrow, and going out to the other, all without constructive receipt by the taxpayer.

Step 8. Taxpayer files form 8824 with the IRS when taxes are filed, and whatever similar document your particular state requires.

(emphasis mine)

Long story short, you sell and buy property but through the Qualified Intermediary and can’t touch the money from the first sale, so the tax burden is deferred.

Overall, you really can’t do this on your own, unless you’re already a CPA, in which case you already knew how to do it probably.

TL;DR

Just some good info on 1031 Exchanges for any readers with investment properties.

Deferring taxes helps here. However, that doesn’t mean tax free, someone pays eventually.

Death, Taxes, and Student Loans, remember?

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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