Sometimes, investors find themselves in situations where they are in possession of real property that they would like to sell. Unfortunately, such a sale will result in a large capital gains responsibility. Therefore, those investors might consider entering into a §1031 tax deferred exchange (§1031 Exchange) as a means to defer recognition of capital gains. Simply, a §1031 Exchange, referring to §1031 of United States Internal Revenue Code, is a normal sale transaction, however, a company is hired to act as a qualified intermediary (QI) to facilitate the exchange.
Before initiating a §1031 Exchange, an investor should contact an attorney, CPA and/or financial advisor for the proper guidance. The QI and the tax and legal advisors will, thereafter, ensure deadlines are met and proper documentation is executed in a timely fashion.
There are many nuances to a §1031 Exchange, so it is important to stay organized throughout the process. Here is a checklist of some important timelines and action steps to consider:
- Select a Qualified Intermediary (QI).
It is important for investors to engage a QI at least 2 weeks prior to the sale of an asset. Unfortunately, if an investor signs the settlement statement and takes the proceeds themselves, they will have voided the possibility of benefiting from a §1031 Exchange and capital gains will be levied.
- Choose Tax and Legal Advisors and have a QI prepare the exchange documents.
Among other things, appropriate advisors will help ensure that necessary language, such as an ”exchange cooperation clause,” is in the contract or purchase and sale agreement.
- Identify a replacement property or trust within the proper timeline.
Investors only have 45 days from the date of the sale of the initial property in order to find a replacement property. Because of this tight timeline, it is good practice to start looking for a replacement property prior to the sale of the initial property.
Alternatively, if an investor is tired of actively managing investment properties, they can seek financial advice on how to exchange into a Delaware Statutory Trust (DST). As with any investment, profitability is never guaranteed but the product does comply with exchange guidelines and allows the investor to take a back seat on the day to day operations.
- Balance the exchange. A balanced exchange ensures a full tax deferral.
- Check the documents.
Confirm that the tax ID number or social security number is the same on both sides of the transaction.
- Notify the QI of the closing and purchase of the replacement property.
The purchase of real property or a DST must be completed within 180 days from the date of the sale of the initial property. If an investor fails to make this deadline, the QI will release the money back and the investor is taxed accordingly.