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1031 Exchange for Dummies: 7 Tips for First-Time Investors

A 1031 exchange gets its name from American law. U.S. Code 1031 states that losses and gains on exchanges of investment property aren’t recognized as long as very specific rules are followed. 


A typical 1031 exchange for dummies article focuses on what the exchanges are and how they work. This article is a little different. We’ll explain how you can make these complicated transactions work for you by following a few tips and best practices. Let’s get started. 


1. Understand 1031 Exchange Deadlines 


In a typical real estate transaction, you have plenty of time to investigate your options and make a decision. You’re only limited by what’s on the market and the money in your bank account. A 1031 exchange is a little different. 


Per the code, you’re required to meet the following two deadlines:


  • 45 days: You must identify your replacement property within this time frame after the sale of the first property. 

  • 180 days: You must complete the sales transaction and take possession of the replacement property within this time frame.


If you miss one of these deadlines, your sale and purchase are no longer part of a 1031 exchange and are taxed accordingly. 


2. Know What Qualifies as a Replacement Property


As the name implies, a 1031 exchange means trading one property for another. However, the trade must involve two properties the IRS defines as “like kind.” 


For example, if you own an apartment building in the United States, you could purchase a similar apartment building in the U.S. in a 1031 exchange. However, if you own a farm in Idaho, you can’t buy an office building in Dubai in one of these transactions. 


IRS rules are designed to allow investors to diversify their portfolios. It doesn’t matter if the properties have similar maintenance requirements or are used exclusively for the same purchase. However, they must both be investments (not homes), and they must both be in the United States. 


3. Ensure Your Replacement Property Makes You Money 


A 1031 exchange comes with significant tax benefits. Instead of paying capital gains on the sale, and instead of paying owed taxes on things like depreciation, you roll your investment into a new property and shield potential profits and taxes. You’re not required to recognize a gain or loss from the transaction. 


However, the replacement property’s value must be equal to or larger than the value of the original. You can’t recognize a loss on your taxes. 


IRS rules don’t allow you to beef up the value of a replacement property with things like artwork, collectibles, or patents. You can use things like irrigation stock, but that option might not be right for everyone.


In general, a replacement property should be very similar in value to the one you’re selling. If you’re uncertain about this requirement, consult a professional. We can help you assess whether the replacement property you have in mind qualifies.


4. Hire a Qualified Intermediary 


All of the tax benefits associated with a 1031 exchange disappear if you touch the sales proceeds. If you sell your property and put the money in your bank account, you can’t use an exchange. Hiring a qualified intermediary is important. 


An intermediary or exchange facilitator holds the funds for you until the exchange is complete. IRS rules don’t allow you to act as your own facilitator, and you can’t use someone like your real estate agent, investment banker, or attorney either. Typically, you must hire someone who specializes in these transactions who might be new to you and your company. 


5. Identify Replacement Properties Properly 


It’s common for new investors to pick a replacement property and forget the all-important notification process. 


Per IRS rules, your replacement property must be identified in writing by you in a signed document delivered to your intermediary and/or the seller of the replacement property. You can’t tell your real estate agent and consider this adequate. 


6. Don’t Forget to Tell the IRS 


Many people assume a 1031 exchange is tax-free. That’s not entirely accurate. These transactions simply defer your tax burden, and the bill can come due when you sell that replacement property. As a result, you’re required to tell the IRS what happened.


You must submit this form when you complete your taxes for the year in which the transaction took place. The form may not trigger payments or tax consequences, but it’s an important part of completing the exchange properly and legally. Skip this documentation, and your 1031 exchange is in jeopardy.


7. Work With an Expert 


The IRS cautions investors to choose qualified intermediaries carefully. Some companies have accepted contracts and then gone bankrupt, resulting in missed deadlines and big tax bills. 


At 1031 Pros, we focus exclusively on 1031 exchanges. We don’t handle any other kind of financial transaction for our customers. Choose us, and you’ll have the expertise and knowledge you need to tackle these delicate trades like a pro. Contact us to find out why we’re a top choice among investors just like you.


References



Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.


Like-Kind Exchanges: Real Estate Tax Tips. (November 2023). Internal Revenue Service. 


Exchanges Under Code Section 1031. American Bar Association. 



About Form 8824, Like-Kind Exchanges. Internal Revenue Service.

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