1031 Exchanges are becoming a very common facet of the commercial real estate industry. Simply put, a 1031 exchange is the swap of one investment asset for another investment of similar kind. The benefit is that you can upgrade your investment without the need to pay a capital gains tax at the time of exchange. With no limit on the number of times you can do a 1031, you are able to continue growing your investment tax deferred until you eventually decide to sell your asset(s) for cash.
However, to be successful with a 1031 Exchange, you have to play by the rules. Here are our suggestions for the 5 must-dos for a smooth and successful exchange.
1. Determine what is deferred capital gains and what is depreciation recapture. Many capital assets use depreciation to spread the cost of an asset over a period of time. This reduces the asset’s adjusted cost basis and as a result, creates a higher capital gain on the sale of the asset. Before beginning the 1031 Exchange process, you will want to ensure your accountant has a firm grasp on these numbers and is able to guide you in the proper way to handle your depreciation and deferred capital gains.
2. Find a qualified Intermediary – reputable, credible and experienced. For the exchange to work, cash from the original sale cannot make it into your own hands. It goes to an intermediary, and hence it’s important that you find a reputable intermediary that can guide you through the process in a proactive manner. The qualified intermediary will work closely with the attorneys, escrow companies, CPA, etc. At Calkain, we’ve developed a strong relationship with Bill Gessner, who we refer clients to on a regular basis. If you have a 1031 Exchange soon to be in the works, you’d be in good hands using ES Group.
3. The property has to be held for investment or business purposes – on both ends of the transaction. It’s a like-kind exchange of a business or investment asset. It is not for personal use. The 1031 cannot be used to swap out your primary residence for another home. Like-kind refers to the nature of the investment. Any type of investment property can be exchanged for another type of investment property. A single-family residence purchased as an investment, can be exchanged for a multi-family building, raw land for a shopping center, or any other business investment. You have the flexibility to change investment strategies to meet your needs as long as it’s business and the debt is equal or greater to the debt on the exchanged asset.
4. Know the timeline. You have 45 days from the date of closing on the relinquished property to identify or nominate potential replacement properties. You must Identify the potential properties (up to three without regard to value, and four or more with value restrictions) that you may acquire, in writing to your intermediary, and it is expected that you will purchase one or more of the Identified properties.
You have 180 days from date of sale to acquire and settle upon the new property. That’s right. You have 6 months to close the deal. NO EXTENSIONS! And don’t forget, this six months is from the date of sale of relinquishing the original property – not upon the completion of the 45 days provided for asset identification. The clock starts running on both rules with the close of the original asset.
Start your search for exchange properties as quickly as possible. It’s imperative to start your search as early as possible and ideally before you sell your original investment. 45 days, let alone six months, goes quickly. If you need help searching out properties, contact a professional today.
Thanks to our friends and contributors from Calkain for their insight into 1031 Exchanges.