How to Start a 1031 Exchange

There are many steps involved in executing a 1031 exchange. In this article, we’ll walk you through all the steps you need to take for a successful 1031 exchange.

Send Your Information to Your QI

The first thing you need to do is provide your Qualified Intermediary (“QI”) with the key details and information about your transaction so they can draft the 1031 documents. Send your QI all of the following:

• The name of the title company closing the transaction

• A copy of the purchase agreement

• A copy of the title report

• The basic 411 on the seller conducting the exchange (sometimes an individual, sometimes a business entity, including the FEIN or SSN).

Document Preparation

Next, the qualified intermediary will gather all of this information, and prepare your 1031 documents and the closing instructions for the title company so they know what needs to be signed at closing. Often the QI will get you to sign your 1031 documents prior to closing and the QI will instruct the title company to have the buyer of the relinquished property sign an acknowledgement stating that they were given notice that the seller is conducting a 1031 exchange. Further, the QI will instruct the title company on how to prepare the closing statement, what to do with the closing proceeds (i.e. wire them in a separate escrow account). The Title Company and QI are doing a lot behind the scenes to make sure the closing is drama free.

Deadlines

Once the closing occurs, you no longer own the relinquished property and your timelines for the 45 day and 180 day periods begin. Closing is day zero, and you have 45 days to designate in writing your replacement property. Once you find a replacement property you will fill out a form with your QI to identify them in writing and transmit that ID form to that QI. The QI will then sign, stamp and date that form and send it back to you for your records. Your CPA is going to want to know when you identified so they can fill out form 8824 – the worksheet you need to include with your tax return.

• Start Your 1031 Exchange: If you have questions about how to start a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What does NOT Qualify for a 1031 Exchange?

Not all property is entitled to 1031 tax treatment. Some assets are excluded outright in section 1031 a(2), such as stocks, notes or evidences of indebtedness, and interest in a trust. Other property doesn’t qualify because it’s not held for business or investment purposes.

Partnership Interest

If you’re in a partnership that owns real estate, your partnership interest cannot be exchanged in a 1031. The partnership itself can do an exchange, but you can’t do an exchange on your interest in the partnership. That’s why a lot of shrewd investors are refraining from buying properties in partnerships and instead opting to title the property as tenants in common.

Tenants in Common Example

Here’s a quick example that shows the benefits of a tenants in common setup. Bobby, Susie, and Steve have a partnership and want to purchase some property. However, to qualify for a 1031 exchange, they purchase a property as tenants in common rather than in the Bobby, Susie, and Steve partnership. That gives them the most flexibility to separately do 1031 exchanges when they sell.

If you do buy property in a tenancy in common, make sure that your CPA is not filing a partnership tax return for all co tenants. This is a common practice because it’s easier to do than to file separate returns for each co tenant. But in order to preserve the maximum flexibility for a future 1031 exchange you want to continue to walk like a duck and talk like a duck.

If you want to have the state-law liability protection of an entity, such as a limited liability company (“LLC”), each co-tenant can form their own LLC to take title to their interest in the real property.  The property can be held by each co-owner via a single member LLC that is disregarded as an entity separate from its owner (unless it elects to be taxed as an association or corporation). The sole owner of an LLC which is disregarded for tax purposes is considered to be in the same position economically as if he/she had taken title in his/her own individual name. 

• Start Your Exchange: If you have questions about what does not qualify for a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What Financial Planners Need to Know About 1031 Exchanges

Most taxpayers like to involve their financial planners when doing a 1031 exchange. While it's a good idea to do this, many financial planners are not experts at executing 1031 exchanges. Here are a few things that financial planners need to know about 1031 exchanges.

Delaware Statutory Trusts

Many financial planners sell securitized investments set up as Delaware Statutory Trusts. These trusts have properties in them and they are subject to preexisting institutional (typically non-recourse) debt. So every owner that goes into that trust will put in their equity but will also be allocated a corresponding amount of that institutional debt.

When you’re sizing up how much replacement property your client needs to satisfy their 1031 you need to look at the specifics of each of those Delaware Statutory Trusts and make sure that the amount of their Value, Equity and Debt in the replacement property is sufficient.

A 1031 Example

Let’s say we have a client who sold a property for $100,000 but had an $80,000 mortgage against their old relinquished property. They need to buy a replacement property of roughly equal or greater value and equity. They also need to offset their debt relief of $80,000. If you put them into a replacement property that’s a Delaware Statutory Trust that has a lower ratio of leverage such as a loan to value of 50/50, then their $20,000 of net proceeds combined with 50% debt to equity won’t qualify as enough replacement property. You either need to find another trust to put them into, or they can fix the problem by putting more cash in (which would in turn increase their proportionate amount of dent allocated to their purchase).

The moral of the story is to put the relinquished property transaction under the magnifying glass. Analyze the equity and debt of your client, and make sure the size, value, and debt components of the new replacement property cover that of the relinquished property.

For more information on this topic, see our blog on the Napkin Test.

• Start Your Exchange: If you have questions about what financial planners need to know about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

Whiteboard Video - What is a 1031 Exchange?

In this whiteboard video, we explain the basics of a 1031 exchange in just over a minute.

If you enjoyed this video, check out our other whiteboard animation videos:

• 1031 Deadlines

• Like-Kind in a 1031

Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

What is a 1033 Exchange?

There are two cousins in the Internal Revenue Code. There’s Section 1031 for voluntary sales, and section 1033 for involuntary sales (i.e. condemnations, requisitions, seizure or losses that may occur through theft, destruction or an act of god).

1033 Involuntary Sales

1033 is the provision for the involuntary sale or loss and it’s actually more favorable to the taxpayer than 1031. In 1033 you don’t need to hire a qualified intermediary. You can hold onto your own proceeds. And you’re not limited to 180 days to complete your exchange – you have 2 years (in certain circumstances that can even be extended to a 3 year period).

Like-Kind & 1033

The like-kind requirement in 1031 is a little more flexible and loose than that for 1033. Generally under 1033 the replacement property must be “similar or related in service or use,” which is a more stringent standard than under 1031. There’s a case where under section 1033 a taxpayer disposed of a bowling alley and replaced it with a billiards parlor.* The IRS said that was not like-kind enough and the exchange failed. So 1033 is perhaps more complex when it comes to the like-kind standard.

Try 1033 First

I would always try to exhaust the 1033 option first because of the longer time frame and the fact that you don’t need a QI. You do however need to file for the election on your tax return to take advantage of the 1033.

Here’s the deal though – 1033 exchanges are rare occurrences. You have to be subject to a threat of condemnation or have suffered an involuntary loss. And many municipalities are gun-shy of litigation and would rather work out a voluntary sale, rather than bring out the big guns and take a condemnation action. I would say that 99% of exchanges are 1031s because voluntary sales are much more frequent than involuntary sales.

• Start Your 1031 Exchangee: If you have questions about 1033 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

*In Rev. Rul. 76-319, 1976-2 C.B. 242, the owner of a recreational bowling center that was destroyed by fire, attempted to replace the property with a recreational billiard center. It was determined that bowling alleys and bowling equipment were insufficiently similar to billiard tables and billiard equipment for the billiard center to qualify as property similar or related in use to the converted bowling center. Similarly in Rev. Rul. 76-390, 1976-2 C.B. 243, it was determined that the physical characteristics and end uses of a motel were insufficiently similar to those of a mobile home park for the motel to qualify as property similar or related in service or use.