Two important time limits to know
When completing a 1031 exchange, you can’t just sell one property and eventually acquire another. In order to complete an IRS-compliant 1031 exchange, there are two important time limits you need to keep in mind:
You’ll have 45 days from the sale of your original property to identify potential replacement properties. You can identify as many as three like-kind properties to buy, or as many as you want if the combined value doesn’t exceed 200% of the sale price of your original property. These properties must be identified in a written document and clearly described with the properties’ street addresses or legal descriptions, and this document must be delivered to your exchange facilitator (more on those later).
You have 180 days from the sale of the original property to close on the purchase of your replacement property or properties. This is when the entire exchange process needs to be completed.
Two points to clarify these rules: These timeframes refer to calendar days, not business days. And if there is more than one property involved in your 1031 exchange, the clock starts when the first property is sold.
Simultaneous 1031 exchanges
A standard 1031 exchange is one where you sell a property, find another you like, and then close on the purchase of the other property at a later date. This is also known as a delayed 1031 exchange. However, it’s not the only type possible.
A simultaneous 1031 exchange, where you sell one property and acquire another at the exact same time, is another option. For example, if two investment property owners both want to complete 1031 exchanges, it’s entirely possible for them to simultaneously swap deeds and have it count as a 1031 exchange. Or a third-party facilitator can set up a simultaneous exchange between buyers and sellers of properties.
Reverse 1031 exchanges
In addition to a simultaneous or delayed exchange, you can complete a 1031 exchange in reverse. For example, let’s say that you identify the investment property you want to buy before your original property sells.
This isn’t terribly common, but it’s perfectly legal to complete a 1031 exchange in reverse. The timeline even works in the exact opposite manner. You’ll have a maximum of 45 days from the purchase of the new property to identify which property you want to sell, and as many as 180 days from the purchase to complete the sale and finalize the exchange.
What if you own an investment property with partners?
In most cases, the rules of a 1031 exchange require that the owners of the original and replacement properties be the exact same person, group of people, or company. If the original property is titled to you alone, the replacement property should be owned by you. If the original property was held in the name of an LLC, the replacement property should be owned by the same LLC.
What this means is that if you own an investment property with partners, you generally cannot sell the property and use only your portion of the proceeds to complete a 1031 exchange.
How to find a replacement property
As I just mentioned, you only have 45 days from the closing of your original property’s sale to identify as many as three potential replacement properties. You don’t necessarily need to buy all of the properties you identify -- if you identify three, you can ultimately acquire one, two, or all three. This window can go by quickly, so here are some good places to start your search:
- Real estate websites (Zillow, Trulia, LoopNet, etc.) can be a great jumping-off point, but finding the best properties for you can be very time consuming.
- If you have a real estate professional you can work with, they can be your best resource. Not only do they have better access to listings than you do, but they’ll spend the time searching so you don’t have to.
- Find a local broker who specializes in commercial properties. These companies by definition typically have lots of experience with investors completing 1031 exchanges.
Calculating the cost basis of the property you sell
Your cost basis on real estate is simply the price you pay to acquire a property, including any acquisition costs. For example, if you pay $150,000 to acquire a property and pay $5,000 in various legal expenses and lender fees, your cost basis will be $155,000.
Over time, your cost basis can change as you make improvements to the property. Continuing our example, if you spend $10,000 on a new roof for the property, it would increase your cost basis to $165,000.
On the other hand, real estate investors can claim a depreciation expense against their rental income each year, and this adjusts the cost basis downward over time.
In a nutshell, at the time you sell a property, your adjusted basis is the acquisition cost of the property plus any capital improvements you made minus the cumulative depreciation you’ve claimed during its holding period.
Calculating the cost basis of the property you acquire
With the above information in mind, when you complete a 1031 exchange, you’re essentially transferring the cost basis of your original property to your replacement property. So you’ll need to calculate your new initial cost basis a bit differently:
- Start with your adjusted basis in the property you sold.
- Add the value of any other property transferred in the exchange, the mortgage amount on the replacement property or properties, the amount of cash you’re contributing to the new purchase above and beyond the sale proceeds, and any recognized gain on the sold property that you might have taken. It’s important to note that not all of these apply to every 1031 exchange.
- Subtract any money or property you received in the exchange, the amount of the mortgage on the sold property, and any recognized loss on any property sold in the exchange.
You can’t complete a 1031 exchange entirely on your own
A 1031 exchange involves selling one property and then using the proceeds to purchase another. This may sound easy enough, but it’s important to realize that you can’t simply do this by yourself and call it a 1031 exchange.
The IRS requires you to use an impartial third party to set up the exchange for you, known as an exchange facilitator. According to the IRS, your exchange facilitator can be a qualified intermediary or a "transferee, escrow holder, trustee, or other person that holds exchange funds for you in a deferred exchange under the terms of an escrow agreement, trust agreement, or exchange agreement."
Generally speaking, you’ll want to hire a reputable and experienced qualified intermediary, or QI, to facilitate your 1031 exchange. This is a person (or company) who will ensure that the 1031 exchange is completed properly on your behalf. The simple explanation of what a qualified intermediary does is that they’ll:
- Acquire the original property from you.
- Transfer the property to the buyer.
- Hold the net sale proceeds in an escrow account.
- Acquire the replacement property you intend to buy from the seller.
- Transfer the replacement property to the borrower.
- Ensure all exchange steps and documentation occur in a timely manner.
A qualified intermediary cannot be your real estate agent. It also cannot be a relative or a person who is related to your real estate agent. Anyone in one of these groups is known as a disqualified person. In simple terms, a QI must not have any major conflict of interest in the transaction.
The steps involved in a 1031 exchange
Confused yet? There’s a lot involved with completing a successful and IRS-compliant 1031 exchange. To attempt to make things a bit easier for you, here’s a consolidated list of the general steps of a standard (deferred) 1031 exchange:
- Identify the property you want to sell.
- Hire a qualified intermediary (QI) to facilitate the transaction. Do this before you attempt to sell the original property.
- Add a relinquished property addendum to any offer you get. This lets you assign the contract to your QI and also makes it clear that you intend to complete a 1031 exchange involving this property.
- Send a copy of your sales contract to the QI as soon as possible.
- Once the sale of the original property has settled, you have 45 days to identify as many as three potential replacement properties. Once you’ve done this, send a letter with details about each one to your QI.
- Once you’ve decided on which property or properties you plan to buy and you have an executed contract on it, send a copy of your purchase contract to the QI.
- Sign an assignment contract for the new property. Your QI should walk you through this step.
- Close on the replacement property within 180 days of the sale of the original property.
- File IRS form 8824 reporting the 1031 exchange with your tax return. Do this for the tax year in which the original property was sold, regardless of when the 1031 exchange is finalized. I strongly suggest consulting a tax professional for this step.
How much does a 1031 exchange cost?
In addition to the cost associated with normal real estate transactions, such as sales commissions and other closing costs, there are additional expenses involved with hiring a qualified intermediary to complete the process.
Qualified intermediaries get paid in two main ways. They generally charge a fee for facilitating the transaction -- this can vary significantly, but it’s reasonable to expect to pay between $600 and $1,200 for a standard deferred 1031 exchange. Expect these fees to be significantly higher if your exchange involves more than one property, or if you complete a non-standard (simultaneous or reverse) 1031 exchange.
In addition to the fee, qualified intermediaries typically make the bulk of their money from interest income that results from holding your money in escrow between the sale of your original property and the purchase of the replacement property. For example, if a QI is holding $500,000 for a three-month period in an account that pays 2% interest, they’ll make $2,500 in interest income. This isn’t a direct cost of a 1031 exchange, but it’s worth knowing about.
The three people you need in your corner
In order to complete a 1031 exchange, you’ll likely need to use the services of three qualified professionals:
- Real estate agent -- If you’re an experienced real estate professional, you might be able to sell and buy the properties without professional assistance, but most people should seek help from a real estate agent, preferably one that has lots of experience in finding 1031 exchange replacement properties.
- Exchange facilitator -- As I discussed, you can’t complete a 1031 exchange entirely on your own. You’ll need a middleman to facilitate the transaction.
- Tax advisor or attorney -- Here’s one of the biggest takeaways from this discussion: A 1031 exchange is a complex tax strategy and there are some situations within a 1031 exchange where there can be some gray area. It’s important to realize that even if you hire a great qualified intermediary, their role is not to give you tax advice. Therefore, it’s important to have a qualified tax professional to help guide you through the 1031 exchange process, as well as the process of filing your tax return after you’ve completed the exchange.
The bottom line is that a 1031 exchange can be an excellent tax strategy for savvy real estate investors, but it’s not a simple process. Be sure you know the process well, and that you enlist the help of qualified and experienced professionals before you attempt to complete a 1031 exchange in your own portfolio.