A forward 1031 exchange can be a powerful way to defer capital gains taxes, but success depends on preparation, timing, and attention to IRS requirements. Before getting started, here are 10 questions to ask yourself to determine whether a forward 1031 exchange is right for you:
1. How much tax would you owe without an exchange?
Start with the numbers. If you sell without a 1031 exchange, you may owe taxes on capital gains, depreciation recapture, state taxes, and the 3.8% net investment income tax. This can amount to 25 - 40% of your gain. If deferral helps you preserve more capital for reinvestment, an exchange is likely worth it.
2. Do you understand the reinvestment requirements?
To fully defer taxes, you must:
Purchase replacement property of equal or greater value
Reinvest all your equity (net proceeds)
And offset any debt relief, with either new debt or new out-of-pocket cash
3. Do both properties meet the intent requirement?
The IRS requires that both the relinquished property (the one you sell) and the replacement property (the one you buy) are held for investment or productive use in a trade or business and not for personal use or quick resale.
4. Are you aware of the critical deadlines?
Forward 1031 exchanges come with strict timelines:
These deadlines are fixed and non-negotiable, even if they fall on weekends or holidays.
5. Do you know how exchange funds are handled?
When you sell your property, the proceeds must go to a Qualified Intermediary (QI), not to you. The QI must hold the funds in escrow:
If you receive or control the funds directly, it may disqualify your exchange.
6. Is the taxpayer consistent on both ends?
The same taxpaying entity that sells the relinquished property must acquire the replacement property. Any change in ownership, even from an individual to an LLC, must be planned carefully and may require legal or tax guidance.
7. Are there any partnership or entity issues to resolve?
If your property is held in a partnership or entity, you’ll need to clarify how the ownership structure affects your eligibility. For example, if partners want to go separate ways, it is best to address this well before closing or even before listing the property for sale.
8. Is there a desire to receive cash?
If the taxpayer wants to take out equity, they’ll need to consider:
Taking boot at closing, which is taxable, or
Refinancing after the exchange, in a way that does not violate IRS rules
Talk to your CPA or tax advisor before making this decision.
9. Is seller financing involved?
If you plan to finance the sale for your buyer, make sure the promissory note is payable to the QI, not to you directly. Improperly structured seller financing may derail your exchange. Also, a trap for the unwary is if you have depreciation, the recapture can come due in the year of the first installment payment.
10. Will there be depreciation recapture?
If you are doing a partial exchange and you’ve previously claimed depreciation on the relinquished property, expect to face depreciation recapture tax even in a 1031 exchange. This component may be partially deferred, but it is critical to account for it in your planning.
Start Your Forward 1031 Exchange
A forward 1031 exchange can be a smart tax strategy, but it is not automatic. By asking the right questions early and working with experienced professionals, including your Qualified Intermediary, CPA, real estate advisors, and attorneys, you’ll be better equipped to navigate the process and maximize the benefit.
Thinking about a forward 1031 exchange? Feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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