How Does a 1031 Exchange Work?

Posted on | by Tom Gustafson

With many property owners preparing their annual investment strategy this month, we wanted to provide a brief refresher on the basics of a Forward (Delayed) Exchange. We often get asked during the Q&A portion of presentations, “How does a 1031 exchange work?” and we’ve done our best to distill the process down to seven primary steps. Though each exchange is unique and should include the input of the Exchangor’s CPA, there is commonality through most exchanges and that is what we will cover. 

The Top Three Non-Starters for a 1031 Exchange 

While there are many reasons why a 1031 exchange would not work, there are three primary “Non-Starters” that we hear often:

  • Primary Residence – Whether an Exchangor is selling a primary residence or selling an investment property to immediately acquire a primary residence, both of these scenarios are not eligible in a 1031 exchange. 
  • “I’ve already closed” – If you’ve already closed there is little to no chance that a 1031 exchange is possible as in most cases the Exchangor has either received the funds or had constructive receipt of the funds where they have the authority to direct an agent holding the funds as to how you’d like them used. 
  • Second Home / Vacation Home – If an Exchangor has utilized their Investment property more as a second home or vacation home and their “fact pattern” is weak regarding their intent to hold the property for investment purposes, this could be problematic should the property come under IRS audit. 

As mentioned, each scenario is unique. If you fall into one of these three categories and would still like to discuss a potential 1031 exchange, we would be happy to hear your unique situation. Or we can further explain how a 1031 exchange works so you’re better prepared for any future transactions.

The 1031 Exchange Process

If you own real property that has been held for trade, business or investment purposes and you’re considering selling the property to reinvest in other real property to be held for trade, business or investment purposes, the first step towards a successful 1031 exchange would be to speak with and evaluate a credible Qualified Intermediary (QI). Review this brief PDF that outlines four questions that you should ask any QI. Once your QI is selected and they have qualified your transaction, a recommended next beginning step is to speak in detail with your CPA about your transaction. When you are confident that a 1031 exchange is in your best interest, the exchange process will move forward as outlined below. 

The Seven Steps of a Forward (Delayed) 1031 Exchange

  1. The Exchangor engages a Qualified Intermediary to accommodate the 1031 exchange by signing an engagement letter and completing a W-9. The W-9 is required by the bank to open a qualified escrow account on behalf of the Exchangor. This must all be done prior to the closing of the Relinquished property. As mentioned earlier, if you’ve already closed there is little chance that a 1031 exchange will be possible. 
  2. Sale of the old or relinquished property is negotiated and a Real Estate Sales contract is signed. Remember to include 1031 assignment language in the contract. This is not required, but it is suggested to alert all parties to the sale of the intent to initiate a 1031 exchange. We would be happy to review the contract if there is any question around whether or not the existing language is adequate. It is also recommended that the Exchangor begin looking for suitable replacement properties as early as possible to ease any difficulty of finding property by the 45thcalendar day. 
  3. At the first of two closings, the Exchangor signs the traditional closing documents and 1031 exchange documents. The Buyer will also sign a Notice of Assignment. The IRS requires that all parties to the exchange are notified in writing. 
  4. Net 1031 exchange proceeds are wired to a custodial banking partner for deposit into a non-commingled, qualified escrow account under the individual’s social security number or company’s employer identification number. If the Exchangor is not a US citizen, then the funds are wired to an account under their international tax identification number or employer identification number if relinquished property is titled to a foreign corporation. There are IRS rules relating to the Exchangor’s access to these funds during this period. Be sure to discuss these rules with your QI. Additionally, in order to fully defer the capital gains taxes and depreciation recapture, the debt (if any) and the net 1031 exchange proceeds must be replaced in the replacement property. A partial exchange is possible, but clearly does not utilize the full benefit of the tax deferral. Tax is triggered on the partial amount not reinvested.
  5. The identification and replacement period begins the day following the closing. The Exchangor must identify the potential replacement properties by the 45th calendar day or the 1031 exchange ends on the 46th calendar day and the 1031 exchange funds are returned to the Exchangor. Replacement property must be purchased within 180 calendar days from closing.
  6. Once a suitable replacement property is found, a Real Estate Purchase Agreement is signed by the Exchangor for the replacement property. Remember to include the replacement 1031 assignment language in the contract. The replacement property must be identified on the 45-identification form to the Qualified Intermediary. If the property is not properly identified, it cannot be acquired. 
  7. Closing is scheduled where traditional closing documents are signed along with 1031 exchange documents. 1031 exchange proceeds are wired prior to closing. After the closing, the final remaining step is for the QI to prepare a summary of the exchange for the Exchangor and their CPA for use in preparing IRS Form 8824. 

While this is the most distilled version of a Forward (Delayed) Exchange, it does provide a common outline to most exchanges of its kind.  Each possible exchange deserves its own attention and dialogue; however, we would be more than happy to discuss yours with you.

We can help 

Atlas 1031 Exchange has been accommodating tax deferred exchanges of all kinds for more than 16 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange. Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.