How Does it Work and What are the Benefits?

In our company, we want our agents to be a resource to their clients even when they are not buying or selling a property.  Keeping people up to date on market conditions, values, and other tools in real estate can be helpful when people are planning for their future- especially when it comes to a renovation, a sale, or another investment. With that in mind, I thought it would be a good idea to explain and clarify a few things about a 1031 Tax Deferred Exchange in real estate transactions.

Most people have heard of a 1031 Exchange in real estate, however, many people tend to misunderstand exactly what it is or how it works.  First, please understand that you should always talk with a tax professional about anything related to your taxes.  Real estate brokers can help you with the real estate, but we are not certified public accountants. It is important that you understand your tax liability before moving ahead with any purchase or sale. 

A 1031 Tax Deferred Exchange is sometimes mislabeled as a tax-free exchange.  The initial thing you should understand is that the taxes are deferred, not removed.  This is probably the biggest misconception of a 1031. The term “1031” comes from the section of the IRS internal revenue code where the rules and regulations are outlined.  In general terms, a 1031 Exchange is when someone sells an investment property for a financial gain and instead of immediately paying taxes on the gain, they reinvest the proceeds of the sale into a new investment property where the taxable gain is deferred. There are certain rules and a process that must be followed to successfully sell and purchase property with a 1031 exchange.

Here’s quick outline:

• You must sell and then buy in the same name.  For example, if you sold a property as 123, LLC you must also purchase the new property in the same name or entity.
• You must declare your intention to use a 1031 exchange in each contract for the sale and the purchase of the property.
• You must coordinate with what is called a qualified intermediary to hold your funds and file other paperwork.  Typically, this is done by a law firm and the fees for the service will vary.  Please understand that if the proceeds of the sale ever come directly into your possession, it becomes a taxable event.  When you sell a property through the 1031 exchange, the money is sent to your qualified intermediary who will then wire the money for your new purchase when the time comes.
• There are time frames involved for completing the exchange from start to finish. For instance, you have 45 days from the sale of your property to identify the new purchase and 180 days to close on the new property with the funds from the sale.

These are the general guidelines and it can be a bit more involved depending on the property or ownership scenario.  Please understand that not every real estate agent is well versed in the process. You should do some research to find someone who has experience in this area and always be sure to check with a tax professional. 

We have seen many people make mistakes when working by themselves or without guidance.  I recall one person calling our office who had recently sold several condos in another area, and they wanted to purchase properties in Athens through a 1031 exchange.  After asking a few more questions, I discovered that the proceeds of their sale were already deposited into their rental property account which is prohibited when doing a 1031.  In this case, the seller should have sought out some advice before finalizing the sale of their properties. 

Recently, the idea was thrown around to do away with the 1031 exchange. Unfortunately, many people don’t fully understand the process or how it can benefit people other than just wealthy property owners.  I am sure that many wealthy individuals have done large exchanges, but we mostly see smaller investment properties sell in our area which create more opportunities for others.

For example, a few years ago, I was the listing agent for a three-bedroom house here in Athens.  The owner did not intend to become a landlord, but they couldn’t sell the property for a loss when the market was down in 2010. So, they began renting out the property and became a landlord.  After learning about the 1031 exchange, they decided to sell the house and possibly reinvest.  As it turned out, the property sold to a couple trying to purchase their first home and not to another property investor.  The buyers had been searching for a home in a very competitive price range and without the 1031, this property would not have been available to them. 

I believe it is a good idea to provide incentives for people to sell property because it creates opportunities for others.  A lot of landlords don’t sell property because of the taxes and therefore those units seldom come available, which results in less opportunities for homeowners and different property investors.  There is also an economic impact to a local economy when someone sells any property.  In the transaction I mentioned earlier, there were numerous benefits from the sale: A young family found a property, two real estate agents were paid a commission, a new loan was originated, and an appraiser was paid along with a home inspector.  Furthermore, the attorney’s office was compensated along with the insurance agent for a new policy.  Several small contractors were paid to make some repairs prior to closing, and after the purchase even more contractors were paid for painting and other improvements. And that doesn’t include the people compensated when the seller purchased a new property. This one home sale helped drive business for numerous people in our community while also benefiting the buyer and seller.  Without the benefits of the 1031 exchange, this seller would not have listed the property for sale and would have continued leasing it out for the foreseeable future.

If you have any questions about real estate, you can always reach out to someone in our company. But always be sure to speak with a tax professional if you have any questions regarding taxes- they are the true experts in that field.