A 1031 exchange allows real estate investors to defer capital gains taxes when selling an investment property. Using an exchange provides many advantages, including the potential for tax-deferred growth, easier estate planning and the opportunity to invest in higher-value real estate. To learn more about how the 1031 exchange process works, read our article. Ready to sell an investment property? Here is a 1031 exchange checklist to keep you on track, and in compliance, when performing your exchange:
The wealthiest investors pay close attention to their cash outflows, which include tax payments. Tax mitigation is one of the easiest and quickest ways to keep a significant amount of money working towards building your wealth. And while 1031 exchanges have the potential to help investors build that wealth, executing a 1031 exchange correctly is critical. Otherwise, a small misstep can disqualify you entirely, leaving you to pay the capital gains. This 1031 exchange checklist can help:
Before You Start
Before undertaking a 1031 exchange, make sure you feel comfortable with the investment and its timing.
Ensure that a 1031 exchange is appropriate for your goals and situation: Understand that a 1031 exchange is an illiquid investment.
Understand the deadlines: One of the most important rules around 1031 exchanges involves the deadlines for the sale of the relinquished property and purchase of the exchanged property. Before starting the process, determine whether meeting the deadlines is realistic for you.
Make Sure You Qualify
We recommend working with a tax advisor before you begin the process of investing in a 1031 exchange. Key requirements:
Type of property: The property you want to sell, or “relinquished” property, must be used for investment or business operations purposes only and qualify as a “like-kind” exchange. Primary or secondary homes do not qualify. See below for the types of properties that qualify (and don’t qualify).
| Qualifying Property | Non-Qualifying Property |
|---|---|
| Multifamily property | Inventory |
| Single-family rental | Personal property |
| Vacant, agricultural or timber land | Collectibles |
| Tenancy in common (TIC) interest | Partnership interest |
| Delaware Statutory Trust interest | Shares in a real estate investment trust (REIT) |
| Leasehold interest (30-plus years) |
Check your financial statements: Make sure financial statements for the property accurately reflect that the property qualifies to be sold through a 1031 exchange and that you can accurately document details such as sales proceeds, amount of debt, etc., on the property. If your statements suggest that the property is being used for development rather than long-term investment, the property could be disqualified from investment.
Period of ownership: There’s no minimum period of time to own a property before exchanging it, but the IRS recommends that you own the property for at least two years.
List Your Property
Now that you’ve confirmed that you’re qualified to go the 1031 route, you’re ready to list your property. Here are the steps involved:
Engage a qualified intermediary (QI): A qualified intermediary is required in the 1031 exchange sale process. As the investor, you cannot take receipt of the sale proceeds at any point. If you do, you will be disqualified. It is highly encouraged to identify a QI as soon as possible. (Need a recommendation? Your Origin representative can help.)
Identify a Replacement Property
Meet the identification deadline: You must identify a replacement property for the relinquished property within 45 days. You can do this in one of three ways: identify up to three properties, utilize the 200% rule, or utilize the 95% rule.
Notify your QI that you have found a property: The QI will prepare and manage appropriate documentation. Remember, at no point can the investor take control of the money. Important: You may only close on properties that were identified with the QI in your 45-day window.
Ensure you have the correct investment amount: There are strict rules when calculating the investment amount to allocate towards your 1031 exchange. You must invest all cash received at the sale. This is typically calculated as the sales price minus closing costs minus any outstanding debt (Use our calculator to help with this).
Understand—and avoid—boot: To avoid mortgage boot, the value of the debt paid off on the relinquished property must be equal to or less than the debt placed on the replacement property. If the mortgage on the relinquished property is more than the mortgage on the replacement property, you would have to either add more cash or pay taxes. To avoid boot, remember three rules:
- Your replacement property must be like-kind and equal or greater in value than the relinquished property
- Your net equity must be “fully spent” when you purchase the replacement property
- Your debt on the replacement property is of equal or greater value than the property you’re selling
Close on the Replacement Property
Set up the buyer purchase agreement: After you’ve identified a buyer for your property, ensure that the purchase agreement of the relinquished property informs the buyer that you intend to do a 1031 exchange. This is done through a buyer acknowledgment provision.
Close on the replacement property: Keep in mind the deadlines for 1031 exchanges. Close on your replacement property within the final, 180-day deadline—and make sure it does not fall on a Saturday or Sunday.
- All exchange documentation must be properly executed before you transfer the property to the buyer. Don’t forget that the QI will need to have the funds in escrow on your behalf.
- Ensure that exchange documentation is properly executed before officially transferring to the buyer.
Inform the IRS of the transaction: Use Form 8824, which calculates the gain deferred from a like-kind exchange. If you transferred property in a like-kind exchange, you must file Form 8824 with your tax return for that year.
There are many moving pieces when embarking on a 1031 exchange, and one small misstep can disqualify your ability to avoid the capital gains tax payment. We hope this checklist brings you confidence in ensuring you are appropriately transacting in a 1031 exchange.
