Let’s Talk About the 1031 Exchange (Tax Deferral Series) - Episode 2

In Episode 2 of this series, I’ll chat a little bit about the detailed mechanics of the 1031 exchange. You can read episode 1 here to catchup!

The Mechanics of the Exchange

As we discussed in the previous episode, a 1031 exchange is a fantastic opportunity to defer (but not necessarily avoid) income taxes until a later date. The essence of the transaction is that the taxpayer will transfer the basis of an asset they sold into a new acquired asset and defer recognition of the gain on sale.

The interesting thing about 1031 exchanges is that the law for these is a blend of statutory law, court cases, IRS Rev Rulings, and other various areas in the body of primary authority we look to. However, to get started, we will first focus on the law itself.

The Overall Steps

Identify the Replacement Property

The first step in a 1031 exchange is to identify the replacement property or properties that you want to acquire using the proceeds from the sale of your current property. You must identify the potential replacement properties within 45 days of selling the current property. You can identify up to three potential properties regardless of their value or any number of properties if their combined value does not exceed 200% of the value of the property sold.

Enter into a Purchase Agreement

Once you have identified the replacement property or properties, you must enter into a purchase agreement to acquire them. This agreement must be contingent upon the successful completion of the 1031 exchange.

Assign a Qualified Intermediary

A qualified intermediary (QI) is a third-party intermediary who acts as a facilitator for the 1031 exchange. The QI holds the proceeds from the sale of the current property in a segregated escrow account until the replacement property is acquired. The QI cannot be someone who has acted as your agent within the past two years, such as your real estate agent, attorney, or accountant.

Transfer the Current Property

The next step is to transfer the current property to the buyer. The proceeds from the sale of the current property are transferred directly to the QI to ensure compliance with the tax code.

Acquire the Replacement Property

The final step is to acquire the replacement property using the funds held by the QI. You must acquire the replacement property within 180 days of selling the current property, or by the due date of your tax return, whichever comes first. You can acquire more than one property as long as the total value of the replacement properties is equal to or greater than the value of the property sold.

We’ll delve into each of these areas in the next episodes.

If you can’t wait until then to discuss, click here to reach out and get in touch.

-Stephen Morris, CPA, MBT, CCIM