1031 Exchange: Deferring Taxes When Selling Real Estate

Learn about the 1031 Exchange, a provision allowing real estate investors to defer taxes. Understand how this provision works, the IRS guidelines and how to select a qualified intermediary.

The real estate market is constantly changing.

For real estate investors, it is important to stay flexible and adapt to shifting market conditions. But there is one major factor that can get in the way of rebalancing your real estate portfolio: taxes.

When selling a real property to fund the purchase of another property, you may be faced with a sizable capital gains tax bill. These taxes siphon away your valuable investment returns and limit the amount you can spend on a new real property.

Fortunately, the 1031 Exchange is available under the U.S. Tax Code. In this article, we are going to explore what a 1031 Exchange is, how to exchange properties under strict IRS guidelines, and the important role of a Qualified Intermediary.

What is a 1031 Exchange?

A 1031 Exchange is a tax deferral tool that real estate investors (Exchangers) can use to build wealth, save on taxes and expand their portfolio.

Section 1031 of the U.S. Tax Code enables Exchangers and businesses to defer the payment of taxes when “real property is exchanged solely for real property of like kind.” When completed properly, this provision opens the door for new investment strategies in the real estate market.

Exchangers can use a 1031 Exchange for:

• Diversification: An Exchanger can sell a high-value real property and use the proceeds to purchase several properties in different markets, or different real property types, to reduce the overall risk of the investment.
• Relocation: An Exchanger can sell in one market and reinvest in another market. This can be done for growth potential, economic conditions or investment opportunities.
• Improved Income Generation: An Exchanger can sell one income-producing real property for another that is perceived to have better income potential now or in the future.
• Estate Planning: An Exchanger can sell a hard-to-manage real property and invest the proceeds into a real property that will be easier for heirs to handle.

The 1031 Exchange Process

The 1031 Exchange process requires careful consideration and planning.

Typically, the Exchanger starts by consulting with their tax and/or legal advisor to plan the sale of their real property. From there, they select a Qualified Intermediary (QI). Once selected, they finalize the sale of the real property and direct proceeds to the QI.

Next, the Exchanger begins the replacement process. They identify a Replacement Property and execute a purchase agreement. Then, they close on that property. The QI disburses funds directly to the title company.

Requirements and Timelines

IRS guidelines for a 1031 Exchange are strict and specific. Fail to follow the guidelines, and you may be faced with a significant tax bill.

The primary requirements for a 1031 Exchange include:

• Like-Kind Properties: The properties sold and purchased must be “like-kind” to qualify for a tax deferral. In the real estate market, this typically means any real property being used for investment or business purposes.
• Title Requirements: The Exchanger must remain the same taxpayer throughout the Exchange. That is, the owner of the Relinquished Property should also be the purchaser of the Replacement Property.
• Reinvestment of Proceeds: Remaining unused proceeds at the end of the Exchange will likely be taxable.

Additionally, there are timeline requirements that must be met, including:

• Identification Period: Within 45 days of selling the initial real property, the Exchanger must identify potential replacement properties. A list of replacement properties must be signed and provided in writing to the Qualified Intermediary.
• Exchange Period: The Exchanger has 180 days from the sale of the initial real property to complete the purchase of a Replacement Property. Importantly, this timeline runs concurrently with the identification period.
  

The Role of a Qualified Intermediary

As discussed, the Qualified Intermediary (QI) plays an essential and required role in the 1031 Exchange process. The right QI partner can help your transaction run smoothly and keep it within IRS guidelines.

When considering a QI, pay special attention to:

• The QI’s credentials and experience
• The process they follow for documentation and funds transfer
• The safeguards they put in place to ensure financial security
• The transparency of their fee structure

Comerica is a Qualified Intermediary, and Comerica’s 1031 Exchange team prides itself on a clear, customer-first approach. Our specialists have decades of experience navigating even the most complex financial scenarios. Funds are secure in FDIC insured accounts and clients receive support from a bank that serves all 50 states.

Looking to Save on Taxes, Maintain Real Estate Income and Preserve Your Estate?

The 1031 Exchange is a powerful tool to accomplish your financial goals. And Comerica provides the sophisticated service you need to execute a like-kind exchange.

Our knowledgeable 1031 Exchange Team consists of licensed attorneys and seasoned escrow professionals. They are available whenever needed to answer client questions throughout the entire 1031 Exchange process. Contact a 1031 Exchange team member to learn more about tax-saving strategies.

This article is written to inform the reader. Nothing in this article is intended to be, nor should be construed as, providing legal or tax advice. Comerica, as a QI, does not provide legal and tax advice. Please consult with your legal and/or tax advisors.