Many real estate investors know that when they do an exchange, they can’t touch the money, they have to identify what they are going to buy within 45 days, and close on any replacement properties within 180 days of the closing date of the property that is sold. While these facts are true, there are some other things to understand ahead of time that will make it easier to have a smooth and successful 1031 exchange. Here are five points to consider.
1. Sign Exchange Documents Before You Close
The 1031 exchange rules allow you to sell your “relinquished” property to someone, and acquire your “replacement” property on a later date from a different person. By signing exchange documents and following the other rules, you can take what would otherwise be a sale followed by a purchase and turn it into an exchange. It’s essential to sign exchange documents on or before the date that you close on the sale of your relinquished property. Exchange documents include an exchange agreement entered into between the real estate investor and the intermediary, an assignment of your rights under the contract to sell the relinquished property and a notice to the buyer of the assignment. On or before the date you close on the purchase, you will also need to sign an assignment of your rights under that contract and you will need to give the seller notice of that assignment. The intermediary assists with this documentation.
2. Think About Who Will Acquire Replacement Property
The same taxpayer who sells the relinquished property must buy the replacement property. What if your lender requires you to acquire the replacement property in a single asset entity? This is workable because a single member limited liability company is disregarded for tax purposes. So, for example, an investor can sell his relinquished property that has been held by him individually and can acquire the replacement property in an LLC as long as he is the only member/owner of the LLC.
3. Buy Enough Replacement Property to Defer All of the Gain
In order to completely defer all of the tax you would otherwise have to pay on the gain, you must do two things. First, you must acquire replacement property that is equal to or greater in value than the relinquished property. So if you sell something for $1 million, you must acquire replacement property worth at least $1 million or the transaction may be partially taxable. Second, you must invest all of your net equity from the sale into the purchase. If you sell something for $1 million that has a $300,000 loan on it, you must invest the full $700,000 you net out of the sale into the replacement property in order to completely defer the taxes. (This example ignores expenses to keep it simple.) To summarize, in this example, you would need to acquire replacement property for at least $1 million, invest $700,000 of cash into it, and then either borrow $300,000 or invest your own funds in that amount.
4. Think About Expenses
There are some expenses that can be paid with the exchange proceeds that will not cause the deal to be partially taxable. For example, brokerage commissions, escrow fees, exchange fees and transfer taxes are generally considered to be this type of expense. On the other hand, when you are selling the relinquished property, if you give the buyer a credit for security deposits or pre-paid rents, you are using exchange proceeds for non-exchange expenses and it could result in your exchange being partially taxable. For that reason, it’s best to come in with your own funds to pay these if you don’t want to pay any tax.
5. Think About Experience and Safety
Your intermediary will provide vital guidance through the 1031 exchange process. You may need special expertise when dealing with seller financing, reverse and build to suit exchanges, dissolving partnerships, and other unique issues that take careful planning and guidance.
Additionally, when you do an exchange, your funds are held by the intermediary until you use them to acquire replacement property. It’s important to find out how those funds are held – are they in a separate account identified by the name and tax ID number of the investor? Are they held in an FDIC-insured bank account or invested in securities? Is the intermediary financially strong and reputable?
These are all important issues to address before you start your exchange.