Nate Kirby, Other/Just Looking in Hometown, IL

How do 1031 exchanges actually work?

Asked by Nate Kirby, Hometown, IL Sun Sep 30, 2007

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Mark Fleysher, MBA’s answer
In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date (e.g., the future resale of the home you will purchase with the proceeds from the sale of a current property).

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0 votes Thank Flag Link Sat Jan 5, 2013
Hi Nate. There's a lot to know about 1031 exchanges and I would suggest that you don't attempt one without getting advice from a tax specialist before you even start the process.

A 1031 exchange is a tax deferral mechanism based on section 1031 of the Internal Revenue Code. It only applies to properties held for investment (not principal residences). Typically, when you sell investment property, you have to pay taxes on the gain. You are taxed differently depending on how long you have held the property. If you meet the requirements of section 1031 you can defer paying the taxes by exchanging like kind investment properties (i.e., you sell investment real estate and replace it with another investment piece of real estate). You can sell land and replace it with a property with a house on it or vice versa or you can replace on property by buying several other properties or sell several properties and buy only one replacement property. You have to trade for a property that is worth equal or more than what you sold (that's a rule of thumb, but how much you actually have to spend depends on not only the price that was paid for the property you are selling but also based on certain expenses that you may deduct (e.g., commissions, closing costs - that's a question for your tax adviser).

In order for a 1031 exchange to be successful you have to do things within certain time frames. You have to identify the replacement property within 45 days of closing escrow on the property that you are selling. Most investors will identify the replacement property(ies) either before or during the escrow period if at all possible. The key is that you have to hire the services of a qualified exchange facilitator that handles the 1031 exchange for you. Most title companies have 1031 exchange services and I would recommend that you go with a company that is associated with a national title company. 1031 exchange companies are not regulated as to how they have to manage the funds that are deposited in their accounts and there were two companies that were involved in scandals earlier this year. These companies are no longer in business, but it demonstrated what can happen when you put your money with the wrong exchange facilitator.

It is crucial that you retain the 1031 exchange faciliator service long before escrow for the property you are selling closes as the proceeds from the sale have to be deposited in the exchange faciliator's account, not your account. Once escrow closes it's too late and you don't want to wait until the last minute before closing to get the exchange faciliator involved.
Once escrow closes you have up to 180 days to close escrow on the replacement property. I say up to 180 days because it can be less than that depending on when you closed escrow on the property that is being replaced as the drop dead deadline is when your tax return is due. So, when you close in December of 2007 and your tax return is due on April 15 of 2008, you don't have 180 days. Again, you tax adviser will give you the details.

There are also rules on how many properties you can identify in the 45 day period (typically up to three, if it's more than three the aggregate value of all of the identified properties cannot exceed a certain $ amount or you have to buy them all to make the exchange successful). You can see, there are a lot of little rules and going through every detail would certainly be beyond the scope of the Trulia forum.

There are lots of online resources you can use to get more information about 1031 exchanges. I have included a link to one of the Internet sites that came up when I googled "1031 exchange"

I would ask your real estate agent for recommendations for 1031 exchange intermediaries.
4 votes Thank Flag Link Sun Sep 30, 2007
Ute Ferdig -…, Real Estate Pro in New Castle, DE
Ute gave an excellent answer. When someone asks a question here, we don't know how much they know to begin with. I spent some time trying to think of an analogy for someone who doesn't know the first thing about a 1031. What I came up with was upgrading your car. You can sell your car and buy another or you can trade your car in and get a credit toward the purchase of the new on. The advantage of trading your car in is that you only pay tax on the difference, not the entire price of the new car. This is not an exact comparison but would give the novice the concept of the program. A closer comparison is that a 1031 is a roll over for real estate investments similar to rolling over the profits on your primary residence to avoid paying capital gains tax. The rules are different but the concept is the same.

Thanks Ute for a wonderfully detailed answer.
1 vote Thank Flag Link Sun Sep 30, 2007
Ruthless, Other/Just Looking in 60558
Read the article I linked below as it answers most of the basic questions, and has links to the IRS tips for 1031 exchanges.
0 votes Thank Flag Link Sun Mar 30, 2008
Ute gave a very good answer! I took a class on 1031 exchanges and the bottom line was to advise the seller to speak to their accountant. I think that's your next step.
0 votes Thank Flag Link Sun Sep 30, 2007
Doubt you'll get a better, more precise answer to question than Ute has posted. While the information she's provided should prove to be helpful in answering your basic question, the best advice is to get a qualified real estate agent as well as an intermediary involved as soon in the process as possible, and definitely before you contract to sell your present investment property. - Steve
0 votes Thank Flag Link Sun Sep 30, 2007
They can be tricky and I don't have time to answer now. Many of our posts need disclaimers such as contact an attorney as we cannot practice law. However, this one is often more of an accountants topic. Are you currently selling or buying? By giving more details, we can better help you. Please post again with more details by hitting "answer this question".

0 votes Thank Flag Link Sun Sep 30, 2007
Ruthless, Other/Just Looking in 60558
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