What is a 1031 Exchange?
If you already own real estate and would like to move into something of greater value, you should consider a 1031 exchange. It is the exchange of certain types of property that may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due. This can be found under Section 1031 of the Internal Revenue Code – 26 U.S.C. § 1031. So, in layman’s terms, doing a 1031 Exchange allows you to avoid paying taxes on the home you sell AND the home you buy (until you eventually cash out… it’s similar to a 401k).
Let’s use Mia as an example.
Mia buys her townhouse for $700k and sells it for $900k. With the money she’s made (plus her $100k in savings), she can afford a $1M condo. This will only take place though if she can avoid paying taxes on her gains. If she doesn’t use a 1031 Exchange, she owes capital gains taxes on her $200k profit, meaning she can’t afford the $1M place. However, if she does use a 1031 Exchange, that $200k is hers to keep, and she can buy the $1M condo!
What’s the catch?
The two main rules…
• The property you’re purchasing must be identified within 45 days after the sale of your old home. This is known as the Identification Period.
• You need to close on your new property within 180 days after selling your old home. This is called the Exchange Period.
You also need a Qualified Intermediary, a person whose job it is to hold your money after you sell and until you buy. Let’s look at that in more detail below…
How can I do a 1031 Exchange?
- Sit down and speak with your CPA. They can give you advice for your situation.
- Sell your property. Make sure to include a clause in your sales agreement stating that the buyer understands you are doing a 1031 Exchange and will work with you (a no extra cost). The closing agent should be able to find a intermediary.
- Enter a 1031 Agreement with the Qualified Intermediary, according to IRS rules. You will need to sign an amendment to escrow naming the qualified intermediary as the seller of your old place. You don’t have to identify our home at this time but you should be on the look out.
- Proceeds of the sale go to the Qualified Intermediary (stay in touch with your Qualified Intermediary). Your money will go into a separate market account. From then, you have 45 days to identify your new home (in writing).
- Identify your new home in writing once you find it to your Qualified Intermediary, the seller and real estate attorney. This written announcement needs to be signed by everyone who signed the Exchange Agreement (You, the Qualified Intermediary, the seller, real estate attorney, and so on).
- Close on your replacement home. Don’t’ forget to include another cooperation clause, which will show the Qualified Intermediary as the buyer. The deed, will show you as the buyer.
- The Qualified Intermediary puts Exchange funds (including growth proceeds) in escrow. They should send you information about your money in the near future.
- When tax season comes, file an IRS form 8824, plus relevant state and local paperwork.