How to Prepare for Your 1031 Exchange
Timing is everything when it comes to a 1031 exchange, and to receive the full tax referral benefits, investors need to be prepared.
“1031 exchanges are a notoriously difficult transaction to do well, and the biggest reason is timing and complexity,” Davin Carey, managing financial advisor at Carey & Hanna, tells GlobeSt.com. “Timing is the big one, and people underestimate how significant that timing pressure it. For a 1031 exchange to be successful, there are a few things that need to happen, otherwise it is not fully tax deferred, or in some cases if you do it wrong, none of the taxes are deferred and they are due immediately.”
The first step begins during the for-sale process on the upleg of the transaction, and this is a step that buyer’s often miss, essentially excluding them from the exchange option. “Even before the property sells, it is really important that the seller notifies the buyer in escrow that they intend to do a 1031 exchange because they proceeds on the date of the closing can never go to the seller,” explains Carey. “The seller can never have constructive receipt of the proceeds. Even before the transaction closes, the seller has to notify escrow that they are going to potentially be doing a 1031 exchange and that they are going to have a qualified intermediary that the proceeds will go to. That actually changes the way that the paperwork is structured. That is a big step. You have to do this before the property closes.”
Next is the crutial timing step. Exchange buyers have 45 days from the close of escrow to identify properties that they would like to buy. This is the biggest challenge for buyers in this market, and a deadline that Carey says buyers are struggling to meet. “To fully do a tax qualified exchange, once the property is sold, you have a 45-day identification window. From the date of the closing, you have 45 calendar days with almost no exception,” he explains. “That window is incredibly strict. If you go past those 45 days and you haven’t identified the properties that you are going to close on, you are pretty much out of luck. It is difficult for people to find properties that they want to buy in that 45 days, and a seller can only purchase properties that they have identified in the 45 days. We usually start working with clients a bit in advance, but that really gets everyone scrambling. It is a big decision on usually a pretty significant amount of money for an investor. That is a challenge.”
Finding a property in this timeframe is difficult, not only because it is a tight and competitive market, but also because the property must meet very specific financial guidelines to qualify for the deal. “There are also rules about how the proceeds must be reinvested for it to count as a full exchange,” says Carey. “It must be real estate to real estate, which is pretty easy. The challenge is that you must replace the total value sold, less selling expenses, with the new purchase or purchases. You must also replace the same amount of debt that you have retired with the new purchase or purchases. You substantially must use the proceeds that went into escrow and the qualified intermediary in the new transaction to fully qualify the exchange.”
Following the 45-day identification window, there is an additional 180 days to close the purchase of the property. This deadline, according to Carey, rarely presents a problem. “It is typically enough time to close the deal,” he says. This is the standard timing for 1031 exchange transactions: sell then buy a replacement property. “On almost every transaction, it is a sale first and then looking for a property,” adds Carey.