How to Set Up a 1031 Exchange: A Step-by-Step Guide

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Key Takeaways

  • A 1031 Exchange is a type of commercial real estate investment transaction that allows investors to defer taxes on the profitable sale of a property held for investment purposes.
  • To complete the exchange correctly, there are a number of rules that investors must follow. For example, they cannot exchange their primary residence or vacation home and they cannot hold a rental property for personal use. To make it easier, the exchange can be broken down into four steps.
  • The first is to identify a Qualified Intermediary.
  • The second is to identify the property to be sold.
  • The third is to identify the replacement property
  • The fourth is to purchase the replacement property
  • The fifth is to inform the IRS about the transaction once complete.
  • For many investors, one compelling option is to use the funds from the sale of the Relinquished Property to purchase the equivalent amount of shares in a syndication.

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A 1031 Exchange, sometimes called a Delayed Exchange, is a specific type of commercial real estate transaction that allows for the tax deferral of capital gains taxes on the profitable sale of an investment property. The financial benefits of executing a 1031 Exchange can be significant, but the logistics of doing the same can be daunting. We’re here to help.

In this article, we are going to provide a step by step guide for investors looking to complete a 1031 Exchange. By the end, readers will have the information needed to begin the process of executing a 1031 Exchange.

At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of this work, we are frequently involved in helping investors place their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about how we can help with your 1031 Exchange, click here.

What is a 1031 Exchange?

In order to understand how to set up a 1031 Exchange, it is first necessary to understand what it is.

As described in the introduction, a 1031 Exchange – sometimes referred to as a like kind exchange or deferred exchange – is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an in investment property – as long as the sale proceeds are used to purchase another, “like kind property”. In 1031 Exchange parlance, the property that is sold is referred to as the “Relinquished Property” and the new property that the sales proceeds are used to purchase is known as the “Replacement Property.”

The rules for executing a 1031 Exchange are codified in section 1031 of the Internal Revenue Code (IRC) and they can be complex. If they aren’t followed correctly, the sale transaction could become taxable and the property owner could be on the hook for a big bill when it comes time to file their tax return.

To simplify the requirements, the remainder of this post provides a high level overview of how a 1031 Exchange works and the steps needed in order to complete one successfully.

Step 1: Find a Qualified Intermediary

If an investor has determined that they would like to complete a 1031 Exchange, the first step is to find a Qualified Intermediary or Exchange Accommodator / Facilitator – a person or firm who is hired to help facilitate the exchange. They are experts in the 1031 field and understand all of the rules, so they are able to facilitate a smooth transaction.

Specifically, the Qualified Intermediary has a couple of very important responsibilities in the transaction:

  • To work with the taxpayer’s attorney, CPA, or other tax advisor to ensure that the rules of the exchange are understood and to set expectations for timing.
  • Prepare, review, or execute 1031 Exchange documents (the Exchange Agreement, Assignment Agreements, Notice of Assignment or Security of Funds Instruments).
  • Oversee or execute transaction closings to ensure compliance with rules
  • Facilitate the sale of the relinquished property on behalf of the taxpayer and purchase the replacement property from the seller
  • Create a qualified escrow account to hold exchange proceeds until they are needed to purchase the replacement property.

In most cases a Qualified Intermediary can be found through a referral from a trusted business colleague, commercial real estate agent, or internet search.

Step 2: Identify The Property to Sell

The very first step in a 1031 Exchange is to identify the property that is going to be sold. In most cases, this is a very straightforward process because most individual investors may only own one or two properties, so it is an easy choice. However, there is a smaller subset of investors who may have larger portfolios of properties, so the decision about which property to sell may not be as obvious. Investors may have to consider things like the market, the planned holding period, lease expirations, and the amount of the gain to be realized.

Either way, the outcome of this step is that a property must be identified for sale and listed with a broker. When the property is sold, the second step is triggered.

Step 3: Identify Property To Purchase

On the date that the Relinquished Property is sold, a clock starts ticking. According to 1031 Exchange rules, real estate investors have 45 days from the date of sale to identify a Replacement Property that they intend to purchase.

Replacement Property must be “unambiguously” described in a written document or agreement. Typically, the property is identified by its street address, legal description or distinguishable name – such as the name of an apartment building.

If the number of replacement properties exceeds one, then these elements should be included in the description of each Replacement Property to be included in the exchange transaction.

Step 4: Purchase The Replacement Property

Once the investor has identified one or more potential replacement properties to purchase, the next step is that they have to complete the purchase(s). Depending on the specifics of the transaction, there could be a one-to-one property exchange or a one-to-many property exchange.

Regardless of the type, the key point is that the investor has 180 days from the sale of the Relinquished Property to complete the purchase of the Replacement Property. This is where the Qualified Intermediary can be most helpful – to ensure that all rules are followed in the completion of the purchase. If they aren‘t, the internal revenue service could determine that the taxpayer has some tax liability in the sale transaction.

Step 5: Inform the IRS About The Transaction

Once the Replacement Property purchase has been consummated, there are a number of steps that must be taken to inform the IRS about the details of the exchange. For example, this type of notification may include details about the types of properties exchanged, the timeframe in which the exchange was completed, the fair market value of the properties exchanged, and whether or not any personal property was involved in the exchange.

This is another place where the Qualified Intermediary can help, because there is a lot of paperwork involved and it must be completed correctly.

When To Start The 1031 Exchange Process

There is no specific moment that the 1031 Exchange process should be started, but the general rule is that as much work as possible should be completed ahead of time because once the Relinquished property is sold, the 45 day identification period begins and the investor is on the clock to complete the exchange in the allocated time period. So, the earlier it is started, the more time the investor has to prepare and may even be able to get a head start on looking at exchange properties that could be purchased.

1031 Exchanges & Commercial Real Estate Syndication

1031 Exchanges are complicated – the tax code sets out a lot of rules that must be followed and the consequences for violating them can be financially significant. For many investors, the biggest challenge is finding a suitable replacement property within the allocated time period. Competition for the most desirable properties can be significant and, if investors aren‘t prepared, they could be forced to settle for a sub-optimal property. This is where a real estate syndication may be a compelling option.

A syndication is a deal structure that allows an investor to purchase a fractional share of a larger asset and still have it count as a replacement property under IRS rules. This is usually accomplished through a Tenant in Common or Delaware Statutory Trust ownership arrangement.

There are two key reasons why it may be beneficial for investors to go the syndication route. The first is speed since it is much easier and faster to find a suitable real estate investment syndication deal. The second is effort because many syndicated deals are managed by a professional real estate firm (like us) and provide a truly passive source of income.

Summary of How To Set Up a 1031 Exchange

A 1031 Exchange is a type of commercial real estate investment transaction that allows investors to defer taxes on the profitable sale of a property held for investment purposes.

To complete the exchange correctly, there are a number of rules that investors must follow. For example, they cannot exchange their primary residence or vacation home and they cannot hold a rental property for personal use. To make it easier, the exchange can be broken down into four steps.

The first is to identify a Qualified Intermediary.

The second is to identify the property to be sold.

The third is to identify the replacement property.

The fourth is to complete the purchase of the replacement property.

The fifth is to inform the IRS about the transaction once complete.

For many investors, one compelling option is to use the funds from the sale of the Relinquished Property to purchase the equivalent amount of shares in a syndication.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners. 

If you are an Accredited 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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