When to Arrange a 1031 Exchange
Terrydale Capital
Nov 8, 2023 13 Min read
If you currently own an investment property but are considering selling it in the near future to purchase another property, you might want to take advantage of a 1031 tax-deferred exchange. By using a 1031 exchange in this situation, you'll be able to defer capital gains taxes as long as you buy a like-kind property. What this means is that anyone who is set to receive a profit upon selling their investment property can use a 1031 exchange to avoid paying capital gains taxes immediately. This guide offers an in-depth overview of 1031 exchanges and the various pros and cons that apply to them.
What Is a 1031 Exchange?
A 1031 exchange is a form of real estate investing that gives investors the ability to essentially move from one investment property to another, after which any capital gains taxes would be deferred until a later date. Without taking advantage of this investment opportunity, you would need to immediately pay taxes on any profits you bring in from the sale of your current investment property.
By effectively trading one investment property for another, these gains won't be taxed and can instead be used to upgrade your property or pay for another investment. If you're looking to perform a 1031 exchange, Terrydale Capital can get you the most competitive terms.
How Does a 1031 Exchange Work?
The 1031 exchange process consists of selling one investment property and using the proceeds to purchase a like-kind property will allow you to postpone your capital gains taxes. Like-kind properties are ones that are very similar in value and nature. Since the proceeds you gain from one property are being used to purchase another, you aren't gaining any income that could be taxed.
Before you can benefit from a 1031 exchange, you'll need to identify what investment property you'd like to sell and which one you want to buy. Keep in mind that investment properties don't need to be the same type, which makes it feasible to use a 1031 exchange when moving from an investment home to a rental complex.
The second step in this process involves the selection of a qualified intermediary, which is someone who will represent you in this transaction. The qualified intermediary is responsible for holding the funds from the sale of your existing investment property in escrow until the full exchange has been completed.
You will then need to inform the Internal Revenue Service about the transaction that you've performed, which can be done with IRS Form 8824. Some of the information that you'll need to include in Form 8824 extends to details about both properties, a timeline for the transaction, the amount of money that's involved, and the people who took part in the process.
When to Consider a 1031 Exchange
There are many reasons why a 1031 exchange could be useful to you as an investor. The main reason to use a 1031 exchange is that you'll be able to reinvest profits into a new investment asset without paying any taxes. With the right approach, you could also invest in a property that provides you with better returns when compared to your existing property.
Some investors will use 1031 exchanges to consolidate several investment properties into a single one. By making this move, you could effectively reset the depreciation that has occurred with your existing property. While vacation homes can't be used in a 1031 exchange, you could turn this home into a standard rental property for a short period of time, which will allow you to perform a 1031 exchange.
Another option at your disposal is to sell the existing investment property before investing in multiple properties. There's no set limit on how many investment properties you can buy with a 1031 exchange. However, there are some additional rules and guidelines that you'll need to follow, which should be described to you by the qualified intermediary you hire.
What You Should Know About Qualified Intermediaries
Qualified intermediaries are individuals who will sell your investment property for you. They will also purchase the replacement asset that you pick out before transferring the deed of the new property over to you. This individual is directly responsible for keeping the proceeds in escrow to make sure that your capital gains can’t be taxed in the interim.
All of the legal documents surrounding the 1031 exchange will be gathered and prepared by the qualified intermediary. They will also make sure that every facet of the transaction is performed in accordance with the IRS guidelines. The following lists some of the many tasks that qualified intermediaries to handle during a 1031 exchange.
| • Provide you with instructions as well as the necessary documents for the title company and escrow |
| • Coordinate with the other seller and yourself about how the 1031 exchange is structured and what it entails |
| • Prepare documentation for the relinquished asset as well as the replacement asset |
| • Handle all of the funds that are obtained from the sale of the relinquished property |
| • Deposit funds into an insured account |
| • Hold funds for a 45-day identification period, during which you will be tasked with finding a replacement property |
| • Maintain written details about possible replacement properties |
| • Transfer funds from the initial sale to cover the costs of the replacement property |
| • Convey the title of the property to the seller |
| • Maintain comprehensive records that the seller will eventually gain access to |
Exact Property and Time Requirements
There are some specific property and time requirements that you will need to adhere to if you want to take full advantage of a 1031 exchange. For instance, the property will need to:
| • Be a like-kind property, which is considerably broader than you might believe |
| • Be similar in function and nature, which means that you can’t exchange a vacation home for a rental property |
| • You’re unable to hold money from the sale of your investment property at any moment while the transaction is ongoing if you want to benefit from a 1031 exchange |
When looking specifically at the various time requirements that are applied to a 1031 exchange, there are two separate timelines that you'll need to be aware of. First, you will have a total of 45 days following the sale of your existing property to identify possible replacement properties.
The replacement properties you find will need to be shared with your qualified intermediary in writing. Once you've closed on your existing investment property, you will have a total of 180 days to close on a replacement property that you find.
PROS:
- No capital gains taxes - Profits from the sale of your investment property can be used to buy another investment property without paying taxes on the proceeds.
- No preset investment criteria - Any funds you obtain can be invested in any like-kind asset throughout any market in the U.S.
- Strong lending options - A 1031 exchange usually results in the investor being able to provide a higher down payment, which should lead to more competitive terms from the lender. Most lenders in the U.S. will provide loans for this type of transaction.
- Did I mention, NO capital gains tax.
CONS:
- Timing - You must identify and close on a new investment property in 180 days.
- Higher prices - In markets where high numbers of 1031 exchanges occur, it's common for investment properties to have high prices because of the increase in demand.
- Limited use of funds - The funds you gain from the sale of one property can only be used to buy another investment property, which means that they can't be applied to fees or other costs related to the loan.
Partner with us Today
Get a quote today. When you use the code "Exchange", you will be given a free appraisal cost waiver with Terrydale Capital financing. We offer 5-10 year loans as well as fixed terms of up to 30 years. Our amortization rates are as low as 5.9%. Full-term interest-only options are also available.
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Headquartered in Dallas, Texas, Terrydale Capital is a leader in commercial real estate financing. We have close relationships with the nation’s top banks, lenders & family offices allowing us to provide the most competitive financing solutions in the market.
