How To Make A 1031 Exchange
Wondering how it works when you want to make a 1031 exchange? Here’s what you can expect from the process.
1. Identify The Property You Want To Sell and Buy
The initial step is to determine which property you want to sell and which property you want to exchange. The property you’re selling and the property you’re buying must be “like-kind,” which means they’re similar, though they may not be the same quality or grade.
2. Choose A Qualified Intermediary
Next, you must work with a qualified intermediary, also known as an exchange facilitator, to handle the 1031 exchange transaction. A qualified intermediary is a person or company that sells a property on your behalf, buys the replacement asset and transfers the deed to you.
The qualified intermediary holds your sale proceeds in escrow until the exchange is complete.
What Does A Qualified Intermediary Do?
A qualified intermediary’s job is to:
- Coordinate with the seller on the structure of the 1031 exchange
- Prepare the relinquished asset and replacement property documentation
- Give instructions and appropriate documents to the escrow or title company regarding the exchange
- Create an arm’s length transaction in the agreement between the seller or exchanger and the qualified intermediary
- Deposit money from the relinquished property sale into a separate, insured account
- Hold the funds from the sale of the relinquished property during the 45-day identification period
- Hold written information about potential replacement properties
- Transfer funds once the replacement property is selected and disburse the money to the title or escrow company to purchase the replacement property
- Convey the title to the seller or exchanger by deed
- Keep complete records for the seller
- Give a 1099 form to the seller or exchanger and the IRS if needed
Choosing The Right Qualified Intermediary
It’s important to choose your qualified intermediary with care so you don’t lose money, miss key deadlines or end up paying taxes.
Confirm that the qualified intermediary you plan to work with offers:
- Real estate experience: Does the qualified intermediary have extensive real estate experience?
- Successful completion of compliance examinations: Intermediaries should meet annual compliance examinations, such as the SSAE 16.
- Transparent transactions: Can you check in on your exchange money at any time? You should always know what’s happening with your money.
- Fund security: Make sure your funds are in an FDIC-insured account.
3. Tell The IRS About Your Transaction
Lastly, you must report the exchange to the IRS by filing Form 8824 with your tax return. You’ll describe the properties involved in the exchange, provide a timeline, explain who was involved in the process and catalog all the money involved.
Both the relinquished property you sell and the replacement property you buy must meet certain requirements:
- Relinquished property: The property you want to sell is the relinquished property – sometimes known as Phase 1 or downleg – gets exchanged for a similar property in a 1031 exchange.
- Replacement property: The property you want to exchange is the replacement property – it's the “like-kind” property purchased with the proceeds from the sale of the relinquished property. This is also sometimes referred to as the upleg of the exchange.
