Your clients may be able to defer taxes on the sale of a property by exchanging it for another property of similar sort and value through a 1031 exchange. By using this strategy, they can maintain their exposure to real estate while keeping more of their wealth to work for them.
However, to benefit from 1031, your clients must follow a rigid schedule. Failure to adhere to the 1031 regulations could lead to the IRS rejecting the transaction, resulting in a substantial capital gains tax payment and lost opportunity.
Here are the crucial procedures and guidelines to be aware of if your clients consider a 1031 exchange.
Relinquishing An Investment Property & Connecting With A QI
Make sure the property qualifies before your client decides to pursue a 1031 exchange as part of their investment strategy. Your customer must have owned the asset for at least two years. Moreover, it must be a property they use as an investment. They must hold the new property they swap for at least two years. This is because the two-year window also applies to the other side of the transaction.
The real estate investor signs a contract to sell their current property to start a 1031 exchange. The next step is for you and your client to choose a qualified intermediary (QI) who will create a legal agreement that enables the exchange and holds the initial transaction’s proceeds, much like an escrow.
For the QI to arrange the exchange, this choice should be made at least three weeks before the close date of the property your client is selling.
Identifying The Right Replacement Property
Your customer has 45 days starting from closing to locate prospective substitute properties of equal or better value. But before finalizing the sale of the home they’re giving up, it’s great if your client has already identified the property (or real estate investment vehicle) they’re interested in. If a client doesn’t know what they intend to acquire, Johnson advises against them performing a 1031 exchange.
By midnight on the 45th day following the closing of the surrendered property, identification of the replacement property must be given in writing to the competent intermediary. But there are a few variations on “replacement property.” It could be:
- Any number of properties, as long as the cumulative value doesn’t rise above 200% of the fair market value of the property being given up; up to three properties, regardless of value
- More than three properties provided that your client gets at least 95% of the aggregate value of the properties, the value of which is greater than 200% of the value of the property being given up.
Keep in mind that any difference between the sale price of the property given up and the price of the property or properties substituted must be reported as a capital gain.
If your client changes their mind about a property, identification forms may be revoked by midnight on the 45th day following the relinquished property’s closing. However, any unused exchange funds will be kept in the exchange account until 180 days if more than 45 days have passed.
Why Can DSTs Be A Good Choice?
Clients can exchange a directly owned property for a Delaware Statutory Trust or DST if they are no longer interested in holding direct real estate. A DST is a business structure that grants accredited investors a portion of a trust’s ownership stake in real estate. DSTs eliminate the difficulties associated with managing real estate directly and enable hands-off investment. They may also offer your client the chance to diversify their real estate holdings and lower tax obligations for loan service or tenant upgrades.
It’s vital to choose the DST or DSTs that best match your client’s goals before or during the 45-day period that starts after your client closes the sale of their surrendered property since, as is the case with all real estate investments, not every DST will be suitable for every customer. And it is best if the DST is established as soon as possible. Johnson claims that “real estate is not evergreen.” “The greatest DST alternatives sell out quickly. Some have filled up inside a day, as we’ve seen.
Replacement Property Closing
Your customer has 180 days from when the sale of the property was finalized to close on the property or properties they’ve chosen. In other words, your client has 135 days to complete the transaction after the 45-day identification period is up. Remember that your client should file a tax extension if the exchange takes place from one calendar year to the next so that taxes can be paid after the exchange has taken place.
It is evident that 1031 exchanges have several highly particular requirements, and controlling their timing necessitates that all parties involved agree with each step’s time. And it might be worthwhile—by adequately carrying out a 1031 exchange. Your client may be able to keep more of the wealth generated by their investment properties. They might be able to postpone paying taxes on the sale of a property in exchange for a stake in a DST or another passive investment vehicle that aims to generate passive income. When working with clients interested in 1031, begin planning early so you can organize every step of the procedure jointly.