1031 Exchange Process And Examples

The 1031 exchange process is a great way to defer capital gains taxes owed on the sale of investment real estate.

At it’s heart, the 1031 exchange is intended to allow two parties to exchange property, but coming across a situation where two parties would each have property the other wants is extremely rare. So the government offers another option. A process for creating a transaction between three parties.

This process is also a 1031 exchange, but requires the cooperation of three parties rather than two.

The first party is you. You are selling one property and the money made on that sale will go directly towards the purchase of another property.

The second party is whoever bought the house you originally owned.

And the third party is whoever sold you the house you bought.

The 1031 Exchange Basic Process

If you have a lawyer to set up your 1031 exchange(and you should), they’ll walk you through the steps. It’s still good to have a basic understanding, at least of step 1. You have to set up the exchange BEFORE you sell!

1. Set up the exchange with professionals before selling

I recommend having a lawyer to walk you through this process. You’ll likely be saving a lot of money, so the cost of a lawyer will ensure that you don’t make a mistake and miss out on all that money.

Since you’ll have a professional to walk you through this, the most important thing you need to understand is that the 1031 process is that it begins before you sell. You’ll need to plan for this.

Now I’ve read about exchanges that were set up minutes before signing the closing documents, but you don’t want that to be you. You probably want to have this thing set up before you ever put up that “for sale” sign.

Now I’ll be honest, when I read through the IRS instructions for claiming a like kind property exchange on your taxes, I don’t see anything about paperwork required before sale of the property. What I do see is required paperwork that all three parties involved in the exchange must sign (parties involved in both real estate transactions). That means even the parties not claiming any tax benefit from the sale must comply with your 1031 exchange process.

Either way, it’s best to get ahead of this thing and find a lawyer before selling your property. And you should be in touch with your accountant before selling as well.

2. Find an intermediary

One important rule in the exchange is that the money from the sale of your relinquished property must not be mixed with anything else. The money must remain safely isolated until it can be used for the purpose of buying your new property.

In order to properly handle this aspect of the exchange, you must find a qualified intermediary.

In short, a qualified intermediary is anyone who is not involved in the exchange and is not a disqualified person (your real estate agent, lawyer, accountant or a family member).

The whole point of the intermediary is to ensure that the funds acquired from selling your property is not accessible for any purpose other than the purchase of the new party.

3. Sell your property and proceeds go to the intermediary

When you partake in a 1031 exchange, there must be documentation signed by all parties, including the person buying the property you relinquish. In fact, it must be signed by you, the party buying the property you sold, and the party selling the property you bought. During the sale of your property you’ll have to get the signature of the buyer. You’ll finalize this paperwork later.

Then the money received from the sale of the property you relinquished will go straight to the qualified intermediary, after it is used to satisfy any debt you had remaining.

Once the intermediary has the remaining money from the sale, it cannot be touched until you purchase a replacement property.

4. Find suitable replacements in 45 days

Within 45 days of the closing date of the sale of your property, you must identify between one and three properties to replace the one you sold. The property you close on will have to be in your list of replacement properties, and you have 180 days to close.

Your identification of these replacement properties must not be ambiguous. There should be no way to confuse which property is being identified. This usually means you need to provide an address.

You should talk to the sellers of your potential replacement properties and verify that they are willing to comply with the rules for the 1031 exchange. In practice, this just means they’re signing some extra paperwork at closing (what’s another few signatures among dozens?). But you never know, some sellers may have a moral stance against allowing investors to defer their capital gains taxes.

5. Close on replacement property in 180 days

Now we’re finally going to close on our new property. You’ve agreed on terms with the seller of one of your replacement properties. Your closing date must be within 180 days from the closing date of your relinquished property.

This is where it all comes together. Your qualified intermediary will transfer the funds from the sale of your previously owned property to the seller of your new property. You’ll officially take ownership of that new property. And you’ll finish out the paperwork required for your 1031 exchange by having the seller sign that paperwork. Now all three parties have signed.

6. Claim your tax benefit

You’ve done everything right, but make sure your accountant knows about your exchange and has all the necessary paperwork for filing the Form 8824, which officially claims the tax benefits of your exchange.

Examples

We went through the basic process, but there are some details that you should be aware of. It’s possible to participate in a 1031 exchange and still owe taxes, even if you don’t actually end up with any cash from the sale of your previously owned property.

As you read through these examples keep these two things in mind:

If you make out of the exchange with cash, you will pay taxes on that cash.
If you make out with less debt, you will pay taxes on that debt relief

Let’s go through a few examples to understand the most important details of avoiding any tax burden in this process. And if these aren’t enough for you I have some additional examples that explore boot in more detail.

Ideal Example

First let’s look at an ideal example. You’re going to sell a property that you own outright and buy one of equal value. Let’s say you have a multifamily unit that provides cheaper housing, but since buying this property you’ve gotten really good at high end rentals.

You want to find a single family home that rents for $2,400 per month in exchange for your six unit property with each unit renting for $400 per month.

Behold! You’ve found another investor in the exact opposite position. They have a high end single family rental, but their specialty is low end multifamily property.

You each have a property valued at almost the same amount. You decide to exchange the properties, one for one.

That means there are no 45 day replacement identification periods or intermediaries or anything. You just exchange properties, sign the paperwork and call it a day.

Example without mortgage debt

OK, this scenario isn’t going to happen. So let’s go through an example that could happen. The simplest real world example is one where you’re selling a property you own outright. You don’t have a mortgage on it and you’ll get the full purchase price when you sell.

Let’s say the property you own is valued at $200,000. If you bought the property when it was worth $80,000, then you’re on the hook for $120,000 in capital gains taxes.

You go through the steps of setting up your exchange, finding an intermediary and finding a buyer for your $200,000 property. You sell the property and $200,000 goes into the account held by your intermediary.

Your search for replacement properties begins immediately and you find 2 properties. One is valued at $200,000 and the other at $280,000.

You make an offer on both properties and your offer is accepted on the property worth $280,000. You close on the property within 180 days of selling your old property, and the seller of this new property signs all the paperwork required for the 1031 exchange.

Your entire $200,000 from selling your relinquished property goes into the purchase of this new one and you take out an $80,000 loan to cover the rest of the purchase price.

You don’t leave the deal with any cash and you end up with more debt than you had before the exchange. That means you won’t have any tax burden from this deal. Great!

Example with mortgage debt

Let’s look at an example now where you’re selling a property you still have a mortgage on.

Let’s say you own a property worth $320,000 and you still have a mortgage with a principle balance of $110,000. Assume you bought the property for $200,000 and had an initial loan principle balance of $160,000. You’re looking at a tax burden of $120,000.

You set up your 1031 exchange, put your property on the market and you sell it for $320,000. The buyer signs your 1031 exchange paperwork. The $320,000 you get from the sale first goes to paying off your $110,000 loan. Then the remaining $210,000 goes to the intermediary account.

Then you begin your search for replacement properties and within 45 days you’ve identified 3 properties. You begin making offers and eventually get an offer accepted on a $450,000 unit.

On closing day your intermediary sends over the $210,000 towards the purchase of the new property and you take on a loan of $240,000 for the rest of the purchase price.

You have the seller of the new property sign off on your 1031 paperwork and you make out with a bigger property and no tax burden.

Example with cash boot

We’ve seen three examples now where there are no taxes owed at the end of the exchange, but that doesn’t mean you can’t be taxed. When you do get taxed on a 1031 exchange, the tax burden is called boot. Boot comes in two forms.

First we’ll look at what happens when you leave with cash in your pocket. We’re going to skip some of the details of the exchange that we’ve covered in the first three examples.

You’re selling a property for $380,000 and you own it outright without a loan. You bought it for $200,000 many years ago. This means you had $180,000 in capital gains.

Selling Price – $380,000
Original Purchase Price – $200,000
Tax Basis – $180,000

You find a house to exchange and buy it for $340,000. You leave the deal with $40,000 in cash.

Cash from Sale – $380,000
Purchase Price – $340,000
Cash Boot – $40,000

So you leave the deal with a $340,000 property and $40,000 in cash. That $40,000 is called cash boot and you will have to pay capital gains taxes on that $40,000.

This is much better though, than having to pay capital gains taxes on the full $180,000 tax basis. You’ve still benefited greatly from the exchange, but the IRS doesn’t let investors leave these deals with tax-free cash.

Example with mortgage boot

There is another form of boot that the IRS will enforce taxes upon. If you carry a mortgage on the property you sell and the property you buy allows you to relieve yourself of part or all of that mortgage, you’ll be paying taxes.

Here’s an example:

You sell a property for $500,000 while there is still a $220,000 principle balance on the mortgage. You bought the property for $360,000, so your tax basis is $140,000.

Selling Price – $500,000
Original Purchase Price – $360,000
Tax Basis – $140,000

After paying off your current loan, you’ll still have $280,000 in cash to put towards the purchase of a new property.

You find a new property and pay $420,000 to purchase it. You put all $280,000 in cash towards the new property, so you have no cash boot.

Cash from Sale – $280,000
Purchase Price – $420,000
Cash Boot – $0

There’s something else that happens though. You had a principle balance of $220,000 on the mortgage for your old property. The new property can be bought with a mortgage of only $140,000. You’ve lowered your debt burden, which results in a mortgage boot.

Original Mortgage Balance – $220,000
New Mortgage Balance – $140,000
Mortgage Boot – $80,000

Because you’ve lowered your debt burden by $80,000, you’ll end up being taxed on that $80,000.

So how do we guarantee that we avoid all taxes during the exchange?

The Two Rules To Avoid Taxes

There are two simple rules you can follow to ensure you will escape the 1031 exchange tax free.

Buy a property worth more than the one you’re selling
Put all the money from the sale of your property towards the purchase of the new one.

The most important rule is to buy a property worth more than the one you’re selling. Because if you buy a property worth less than the one you’re selling you’ll end up with some form of boot that will be taxed.

You can still end up with boot if you buy a more expensive property if you take cash out of the sale of your relinquished property. So following the second rules guarantees that your own behavior won’t result in taxation.

Conclusion

While the 1031 exchange process can be quite complicated in certain situations, it’s usually simple.

You set up your 1031 exchange paperwork. Sell your property and get the buyer to sign the paperwork. Send the money to an intermediary. Find suitable replacement properties within 45 days, and close on one of them within 180 days, getting the seller to sign your 1031 paperwork. Then don’t forget to file your Form 8824 at the end of the process to get your tax break.

The 1031 exchange should be a tool in every real estate investor’s tool box.

Happy investing.