Section 1031 of the tax code outlines a leasing regulation that allows businesses and business owners to exchange property and defer taxes. This principle is known as a 1031 exchange. Under a 1031 exchange, like-kind property may be swapped for property of similar class and nature, thus avoiding taxes until the property is ultimately sold for cash. Executing an exchange can be cumbersome, but it can also allow businesses to maximize capital gains on commercial property. Below is a step-by-step guide designed to simplify and streamline the operations of a standard 1031 exchange.
Step 1. Decide to do a 1031 Exchange
A 1031 exchange can be extremely advantageous, but some purchases are more profitable to perform in a typical manner than in an exchange. This particular leasing regulation has many considerations such as legal requirements, qualifications, document filing, and fees or other associated costs. Deciding to undergo an exchange should be discussed with a qualified commercial real estate firm to clarify these considerations and to ensure a rewarding venture.
Step 2. List the Relinquished Property for Sale
Once the decision is made to administer a 1031 exchange, the next step is to list the relinquished property for sale. Depending on the type of 1031 exchange, several regulations dictate the timeline given for finalizing this step. The real estate agent must include the proper language in the listing to make potential buyers aware of 1031 compliance.
Step 3. Search for Replacement Property
If the desired, new property isn’t previously selected, the business owner must begin search for replacement property while the relinquished property is on the market. As soon as the relinquished property is sold, the 45-day window to identify the replacement property commences. Section 1031 of the tax code offers specific rules and parameters with regards to determining a replacement property.
Step 4. Delegate a Qualified Intermediary
A 1031 exchange often requires the utilization of a qualified intermediary. A qualified intermediary acquires and retains the proceeds or titles from the sale of the properties until they are finalized. Acting as an “in-between,” an intermediary enters into a written exchange agreement with the investors, buyers and sellers that clearly restricts and limits their ability to obtain any benefits of the exchange without the intermediary’s consent.
Step 5. Close the Sale of the Relinquished Property
With the help of the qualified intermediary and the real estate team, the next step of a 1031 exchange involves accepting an offer on the relinquished property. The documents associated with the closing must expressly state the terms and the buyer’s acknowledgment of the 1031 exchange. The close of the sale on the relinquished property is similar to any standard real estate transaction, though the funds are transferred into the intermediary’s account instead of into that of the exchanger.
Step 6. Identify Replacement Property
After finalizing the sale of the relinquished property, the exchanger must identify a like-kind replacement property within 45 days. The identification must be stated in a written document and signed by the investor and intermediary. Identification of replacement property can also be revoked or changed within the identification period. The rules of selecting a replacement property give the business or business owner the ability to identify up to three properties of any value, unlimited properties that total less than 200 percent of the value of the relinquished property or unlimited properties regardless of value as long as 95 percent of them are acquired.
Step 7. Close on Replacement Property and Finalize the Exchange
The investor, intermediary, title company and agent work together to finalize and close the exchange. Closing costs and processes of a 1031 exchange include fees, premiums, security deposits and more. Correctly categorizing these expenses requires all participants’ coordination. Once the acquisition of the replacement property is completed and the title is secured, the intermediary transfers the funds and title to the exchanger, which finalizes the exchange.
Interested in a 1031 exchange to defer taxes and increase your investment? Ground + Space is a leading commercial real estate brokerage firm that specializes in single-tenant and retail NNN investments. Contact us today to find out more about our current listings!