1031 Exchange Checklist for Investors to Follow

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Key Takeaways

  • A 1031 Exchange is a commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as the sale proceeds are reinvested/used to purchase a like kind property.
  • There is some complexity and tight timelines to a 1031 Exchange so it can be helpful for real estate investors to work from a checklist.
  • Steps on the checklist include consulting tax and legal advisors for suitability, finding a qualified intermediary, selling the property, finding a replacement property, and purchasing it.
  • The checklist assumes that an investor is selling and purchasing a property on their own. For investors looking for passive income and a fractional share of a larger property, it may be a compelling option to work with a private equity firm.

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1031 Exchanges are very popular with investors, but they can be complicated and the consequences of violating one or more of their rules can be financially very costly for taxpayers. To maximize the chance that the transaction receives full tax deferral, it is helpful to work from a checklist.

In this article, we are going to describe a 1031 Exchange checklist for real estate investors. In doing so, we will explain what a 1031 Exchange is and walk through each of the steps necessary to complete one. By the end, readers will have a better idea of what goes into completing a 1031 Exchange and will have the information needed to decide if one is a good fit for their needs.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. If you are an accredited investor and would like to learn more about our current opportunities, click here.

What is a 1031 Exchange?

A 1031 Exchange, sometimes called a like kind exchange or tax deferred exchange, is a type of commercial real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property – as long as the sales proceeds are reinvested into a new property that is like kind to the one that was sold.

The rules for completing a 1031 Exchange are defined by the Internal Revenue Service (IRS) and are outlined in section 1031 of the Internal Revenue Code (IRC). They include:

  • The new property must be like kind to the one that was sold. In general, most commercial properties are like kind to other commercial properties. For example, an investor could exchange an office building for a small multifamily apartment building. But, they could not exchange a primary residence or single-family vacation home for a retail center.
  • Investors have a 45 day identification period from the sale date of the “relinquished property” to formally identify the new property that they plan to purchase, referred to as the replacement property. They have 180 days from the sale date to complete the purchase.
  • The debt and equity in the relinquished property at the time of sale must be equal to or greater than the debt and equity in the replacement property.
  • The titleholder for the relinquished property must be the same as the titleholder for the replacement property.

Given these exchange rules, and others, it can be seen that there is a lot of complexity in this type of transaction. To get through it, it can be helpful for investors to work from a checklist.

1031 Exchange Checklist

There are eight steps on our 1031 Exchange checklist. They are listed below.

Item #1: Consult Tax and Legal Advisors

When considering a 1031 Exchange, the very first step is to consult with tax and/or legal advisors to ensure that this type of transaction is suitable for investor needs.

For example, every investor has their own risk tolerance, time horizon, return objectives, and need for liquidity. As a result of these differences, every investor has their own needs in a transaction. These needs should be discussed with a qualified CPA or tax attorney to determine if a 1031 Exchange is suitable.

Item #2: Find A Qualified Intermediary

A Qualified Intermediary, sometimes called an exchange accommodator, is an expert in 1031 Exchange rules and it is their job to make sure the property exchange transaction runs smoothly. Often, they may take title to the property once the sale closes and hold the proceeds in escrow until the completion of the exchange. In addition, they advise their client to make sure all rules are followed.

So, if it has been determined that a 1031 Exchange is suitable for an investor, the next step is to find and hire a Qualified Intermediary to facilitate the exchange process. In most cases, they can be found through an internet search or with a recommendation from a colleague or fellow investor.

Because Qualified Intermediaries hold exchange funds in escrow, investors should ensure that potential candidates have the financial strength to remain in business for the duration of the exchange.

Item #3: Prepare Exchange Documents

With the Qualified Intermediary identified, the next item on the checklist is to work with them to prepare the necessary exchange documents. These may vary slightly depending on the type of exchange, but there are two key points.

First, in the purchase and sale contract for the property to be sold, a clause known as the “exchange cooperation clause” should be added so that all parties are on the same page that the intent of the seller is to complete a 1031 Exchange.

Second, the Qualified Intermediary should prepare all of the necessary documents to convert the transaction into an exchange. These documents must be completed before the sale of the relinquished property and failure to do so may cause the transaction to become taxable.

Item #4: Sell The Old Property

With the Qualified Intermediary lined up, the next item on the checklist is to sell the property. While it may sound simple, there are actually a few steps here.

The first is to select the property to sell. In many cases, an investor may only own one property so this decision is a no brainer. However, if an investor owns multiple properties, they may need to take a moment to determine which property to sell into the exchange.

The second step is to hire a broker/realtor to help market the property. While investors do not have to hire a broker, it is the standard procedure for selling a big commercial rental property. The broker has local connections and clients and provides the proper guidance on setting the sales price. In addition, they will help negotiate the deal and will handle the logistics through closing.

Item #5: Identify Replacement Property

Once the relinquished property is sold, a clock starts ticking on the closing date.

Think of the closing date as “day 0” and investors have until the end of the 45th day to formally identify a replacement property that they intend to purchase. A few points on the replacement property.

First, it has to be a like kind property to the one that was sold. Again, most commercial property is like kind to other commercial property.

Second, the market value of the replacement property must be equal to or greater than the value of the relinquished property.

Third, investors may identify one property that meets the market value test. Or, they may identify up to three potential replacement properties, regardless of value, as long as they close on at least one of them. Or, they can identify as many replacement properties as they want as long as they do not exceed 200% of the value of the relinquished property.

Fourth, the replacement property must be formally identified in writing, usually with the address or legal description, with the Qualified Intermediary.

Investors must pay close attention to the clock because 45 days can go quickly and failure to properly identify a replacement property within the required time frame could cause the transaction to become taxable.

Item #6: Enter Into a Purchase Contract

Once the replacement property has been identified, the next item on the checklist is to enter into a purchase contract for it.

This is one particular place where the Qualified Intermediary and/or attorneys can be particularly helpful. As described above, they need to make sure that the purchase contract contains all of the language necessary to indicate that it is the seller’s intent to perform a 1031 Exchange. In addition, they need to ensure that the planned closing date will meet 1031 Exchange requirements.

Item #7: Balance The Exchange

There are a number of rules regarding the value of the exchange properties that investors must abide by. To ensure this is the case, the next item on the checklist is to balance the exchange. To do this, it is necessary to:

  • Ensure that the replacement property is purchased for at least as much as the relinquished property is sold for
  • Take all of the cash proceeds from the sale of the relinquished property and reinvest all of them into the purchase of the replacement property
  • Ensure that the debt on the new property is at least as much as the debt on the relinquished property
  • Ensure that no personal property or cash proceeds are received in the transaction. If they are, they are known as “boot” and they are taxable.

This item is where the Qualified Intermediary earns their fee. It is their responsibility to guide the investor through the balancing process to make sure that there is no tax liability as a result of the exchange.

Item #8: Close on the Property

Of course the last step is to close on the purchase of the property. However, the timing is critical.

Investors must complete the purchase of the property by the end of the 180-day exchange period. Or, put another way, they have an additional 135 days past the 45 day identification period to complete the purchase.

The Qualified Intermediary has a role to play in the closing as well. They ensure that the title is transferred to the proper parties and they take the funds out of escrow and make sure they are distributed to the proper parties in the right amounts.

Once the purchase of the replacement property is complete, the 1031 Exchange is also complete.

1031 Exchanges & Private Equity Real Estate

From this checklist, it can be seen that a 1031 Exchange can be a complicated transaction with tight timelines. But, the checklist above assumes that an individual investor is the one selling and buying the properties involved. This is often the case, but not always.

In certain situations, it may make sense for an individual investor to partner with a private equity firm in the purchase of a replacement property. In such a scenario, the taxpayer may use their sales proceeds to purchase a fractional share of a commercial property using a tenants in common ownership structure. There are two major benefits to this approach. First, an investor may get the benefit of the scale of a larger, more efficient property. And, second, these properties are usually managed by a third party which means that they produce passive income – which makes them a good fit for investors who want the benefit of property ownership, but not the hassle of managing it.

Summary of 1031 Exchange Checklist

A 1031 Exchange is a commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as the sale proceeds are reinvested/used to purchase a like kind property.

There is some complexity and tight timelines to a 1031 Exchange so it can be helpful for investors to work from a checklist.

Steps on the checklist include consulting tax and legal advisors for suitability, finding a qualified intermediary, selling the property, finding a replacement property, and purchasing it.

The checklist assumes that an investor is selling and purchasing a property on their own. For investors looking for passive income and a fractional share of a larger property, it may be a compelling option to work with a private equity firm.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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