Realty Exchange- How a 1031 Works

A realty exchange, if done correctly, can eliminate or indefinitely defer any capital gains you have on the sale of an existing property. This is an important topic even if your property has lost a great deal of value. Why?

Over the years, you’ve taken depreciation write-offs and that has lowered the cost basis of your property. As a result, you might have to pay taxes on selling your house even if it’s worth less than you owe on it. That’s ugly. And if that’s the case, a realty exchange – otherwise known as a 1031 exchange – can help.

How does realty exchange 1031 work?

Rather than sell the property outright, exchange it for a similar property and keep those tax dollars in your pocket. Of course, if you’re sick and tired of owning real estate this isn’t going to work for you. But you might be interested in dumping your existing property in exchange for something easier to manage or one that has greater cash flow. And with real estate prices this low, now may not be the time to exit the market completely.

In order to make this work, we have to be dealing with investment real estate. And you can’t exchange an investment property for a vacation home or residence. It has to be like-kind. The good news is you can exchange any kind of investment property for any other kind of investment property. For example, if you own a hotel in Hollywood, you can exchange it for a warehouse in Washington. Anything goes. If you want to sell your house and become renters you can do so and still take advantage of this technique. Just rent your house out now and live in a rental yourself before you sell it.

What are the mechanics of this?

In order to execute a reality exchange and not incur the taxes you really have to be mindful of the details. The first order of business is to find a qualified intermediary. This person is going to act as an escrow agent of sorts. When you sell your property, you can’t touch the proceeds. And when you buy the new property, you won’t be directly involved in that either. The qualified intermediary does all this for you.

This intermediary can’t be someone you have a professional relationship with and it can’t be a family member. I recommend that you only use a professional and bonded qualified intermediary because they laws are very particular. And if they fail to follow the exact letter of the law, the realty exchange won’t pass muster and you’ll owe the tax on the sale. Also, make sure you have a qualified attorney and CPA who are experts in these exchanges. One minor mistake and you’ll be a world of pain. Back to our exchange.

In order for the tax free realty exchange to work, the new property must cost at least as much as the old property. If you invest less than the proceeds you receive from the sale of the old property, you’ll owe a tax on the difference.

Once your old property is sold the proceeds are sent to the intermediary and held in escrow. Then, the money is used to buy the new property and you are done. No tax. Nice.

Stipulations

First, you have to submit a written list of potential new properties to the intermediary within 45 days of the sale of the old property. You’ll want more than 1 property on that list just in case the deal doesn’t go through. But the total value of the property on this list can’t exceed 200% of the proceeds from the sale of the old property.

Next, you must complete the sale of the new property within 180 days from the day you sold the old property.
I was recently involved in a transaction of this kind and it was very straight-forward. While at first I was intimidated by the process, I found it pretty simple.

The key was having the right qualified intermediary, CPA and attorney. If you enter into a transaction such this, make sure you identify a good person who will take the time to explain the process to you in plain English and who will answer all your questions.

Have you been involved in a 1031 reality exchange? How did it work out for you?