David Moore with Equity Advantage examines 1031 exchanges. A 1031 exchange is a wonderful tool for investors, but it is wise to know the guidelines and the timelines if you are thinking of using one. Learn about the value of planning ahead to protect yourself from unwanted tax exposure.

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When Do I Have to Start a 1031 Exchange?

The 1031 exchange process has been around since the 1920s, but final guidelines were issued in 1991, and it simplified the process a lot. But the biggest thing you have to remember anytime you look at or contemplate an exchange is that it has to be established before you have actual or constructive receipt of the funds.

Here is what that means: If you close a deal, even if you’ve never touched the money, it’s constructive receipt, which means you have tax exposure. So, you have to make sure you take care of these things in advance. People ask me all the time when I’d like to see them think about the exchange, and I’ll tell them that the time to start thinking about it is when they buy the property—because nine times out of ten they’re going to sell the thing at some point. If you don’t buy it correctly, you won’t be able to sell it either. This makes it important to understand ownership and how it impacts what you want to do.

But the most important thing with any transaction is before you ever go to sell it, understand what the tax liability is. Decide whether you want to do an exchange, whether you want to pay that tax, whether it’s the right time to pay that tax. But if you want to do an exchange, it has to be established prior to settlement.

How Can I Start a 1031 Exchange?

The 1031 exchange is really a simple process. Think of it this way. You’re going to sell a property, you’re going to buy a property, and we’re going to step into the middle of the whole thing and turn it into an exchange. So, how do we do that? We do that by having you assign the rights and obligations of ownership to us pre-settlement and you’re going to assign that purchase sale agreement to us.
We actually assume all rights and obligations of you as a seller of the property. When it closes, we sign as a seller. You’re going to sign things, read and approved as the exchanger; and the deed is going to be direct deeded from you to the buyer of the property. But the exchange, always remember, is between you, the taxpayer, and the exchange company—not you and the buyer or you and the seller of the replacement property.

Could you negotiate the purchase before the sale ever happens? Yes, you can. Go ahead and negotiate the purchase, do everything short of closing on it, and that’s totally fine. We can once again draw that assignment agreement when it comes time to close. If you had to close before the sale happens, well, that doesn’t kill you either as long as we’re involved prior to the closing, so we can do what’s called a reverse exchange if necessary.

I always encourage people to look at that as a fallback, not a primary objective, for a variety of reasons. But if we’re looking at a basic delayed exchange, simply think of it this way. You’re going to give us something. We’ve got to give you something back. It’s a give and receive, and they have to be of like kinds; that’s the basic idea. It refers to the nature of the investment rather than the form. People call up all the time, say, “Well, I gave up a rental house. Do I have to receive a rental house?” Not true. Give up the rental house, go out and buy an office building, strip mall, place at the beach, maybe even move in to it someday. All those things are possible. For you to be totally tax-deferred, you need to go across or up in value and equity.

How to Get Started with a 1031 Exchange for Real Estate

Finally, we have to have continuity investing. That just means that the person that gives us something has to be given something back. As far as the process is concerned, what we need is your contact information: name, address, phone number, email address. We’re going to need know who’s handling the closing, the escrow roster’s name, escrow roster phone number. If you’re someplace that works with lawyers closing the deal, get us that person’s information. If you don’t have the escrow number, you can just get us the seller’s or the buyer’s name and the property address, and we can reference the transaction that way. At that point, we’re going to reach out to escrow, get a copy of the purchase sale agreement, the title report, and draw up our exchange agreement. That’s going to be between you, the taxpayer, the exchange, and Equity Advantage. We’re going to draw up the assignment agreement, which actually allows us to do what we need to do.

We’re going to put escrow instructions together, telling escrow what to do. As I said before, really we’re just being put on as a seller of the relinquished property, buyer of the replacement. You’re going to sign, read, and approve as the exchanger. As soon as that property closes, as soon as we get final settlement statements, we’re going to send out what we call an ID packet. The ID packet is going to give you the 45th and the 180th days. It’s going to give the identification rules and it’s going to contain a form that’s to be filled out and returned to us (by fax, email, or delivery) prior to midnight on the 45th day. There are three different identification rules. You only have to work with one of those. If you want details on that, you can look at one of our other videos or give me a call.

Regarding identification, you can change your mind anytime up until that 45th day. So, if you turned in one on day 10, that’s fine. You can change your mind day 20, 30, 40. A common misunderstanding is that a property has to be listed to be identified, but that’s not necessary. Does a property have to be listed with someone to be purchased? Do you have to use a broker to buy or sell something? No, you don’t. So, whether it’s on the market at the time of ideas is really irrelevant. You’ve got to give what the government would deem an unambiguous description. You’ve got to receive substantially the same thing. If you are buying with other people, picking up less than half of it, you need to identify the portion you intend to be picking up.

As far as earnest money on acquisition, put that down anytime. If you’ve negotiated a purchase before the sale happens, that’s totally fine. Let us know whether you want to be reimbursed the earnest money when we go to close on that property. If we have funds, we can forward earnest money. If we have your funds, we can forward the earnest money on your behalf. We’ll do that after we’ve put the assignment agreement together and had it signed by both you and the seller of the property. We can release those funds on your behalf. Escrow is going to be open as it normally would be. Then, at closing, once again we’re going to be signing things as the exchange. As the actual buyer, you’re going to be signing things as the exchanger of that transaction. And at settlement, we’re signing that way. You’re reading and approving.

The deed is going to go from that seller directly to you. Upon close of that, we’re done with the exchange, assuming it’s one to one. Now remember, you can give up one property, buy one, or buy ten. You could give up ten and buy one, but you’ve only got that total 180-day period to get things handled, so keep that in mind. That’s the toughest thing. The 45-day window actually is the toughest thing with the transaction.

When we’re all done with the acquisition of the replacement properties, we run out of time. Get your deal completed. We’re going to send out one last set of documents. It’s a term pack that summarizes what was relinquished and what was received. It’s going to give a full accounting for the funds. And you’re going to give that information to your tax people, along with settlement statements from the relinquished and replacement properties, and they’ll do the tax work for you—doing the basis carry forward calculations, the 8824 form, for reporting purposes.

If you look back at what happened when the exchange is completed, you sold a property or properties, you went out and bought the property or properties you wanted, and they didn’t have to all happen at the same time. You’ve got that 180-day window to get things done. If we do something that we call a blended transaction, where we’re combining a reverse and improvement, you can almost get up to a full year. But typically we’re looking at that 180-day window to get things taken care of.

All 1031 exchanges are complex. Using an exchange accommodator like Equity Advantage puts a professional in your corner who knows all the rules. It just takes a phone call to get started: 503-635-1031.