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  • Writer's picturePGC Team

1031 Exchange Process: How it Works, Steps & Tips

Updated: Aug 31

For many investors, a strategy that involves a 1031 exchange can be an excellent way to build a portfolio. A 1031 exchange allows you to defer payment of capital gains taxes on real estate gains, which lets you maximize the amount you put into your subsequent real estate investment.

However, the process is very specific, and there are many limitations. Mistakes in the process could result in having to pay a significant amount in taxes sooner than you planned. It is extremely beneficial to work with a company to help you through the process.

For those who wish to learn more, consider what the 1031 exchange process looks like.

Real estate investment. House model, calculator and contract on wooden table

What Qualifies as a 1031 Exchange?

An important rule to remember is that 1031 exchanges generally apply to business or investment properties. Personal use properties, such as primary residences or vacation homes, typically do not qualify.

Additionally, these securities and financial instruments are usually ineligible for 1031 exchanges:

  • Stocks

  • Bonds

  • Inventory

How to Do a 1031 Exchange

The goal of a 1031 exchange is to defer capital gains taxes when you relinquish one real estate investment property to invest in another of equal or higher value.

If you simply sold the property and took the cash, you would have to pay capital gains taxes in that tax year for any appreciation you realized. Here’s a look at the basic steps involved when you participate in a 1031 exchange:

Here’s a look at the basic steps involved when you participate in a 1031 exchange:

1. Assess the Suitability of a 1031 Exchange for Your Situation

Before diving into a 1031 Exchange, you must evaluate whether it aligns with your circumstances. Several factors should be considered, such as:

  • property ownership structure

  • potential tax obligations

  • liquidity requirements

  • financial and lifestyle goals

  • market timing

  • debt considerations

To determine the suitability of a 1031 Exchange, we recommend scheduling a complimentary consultation with Precision Global Corporation.

2. Determine the Property You Intend to Sell

In a 1031 exchange, you must identify the property you plan to sell. However, 1031 exchanges typically apply to business or investment properties. Properties used for personal purposes, such as primary residences or vacation homes, generally do not qualify for this tax-deferral strategy.

Ensuring that the property you intend to sell meets the business or investment property criteria is crucial to successfully proceed with a 1031 exchange.

3. Identify the Property You Wish to Acquire

When selecting a property for a 1031 exchange, you must ensure it qualifies as "like-kind" to your selling property. "Like-kind" refers to properties that share the same nature, character, or class, although they do not have to be of the exact quality or grade.

4. Identify a Qualified Intermediary

The IRS has specific rules about how money is moved during a 1031 exchange. In short, you, as the investor, will not receive any cash in hand for relinquishing the original investment property. Instead, the cash is moved through a third party — a qualified intermediary, or QI, who works on your behalf.

The QI handles the funds from the sale of the property. This party eventually will reinvest the money into a quality property that you elect to purchase. After you choose a QI to represent you, you can move forward.

5. Determine the Allocation of Sale Proceeds for the New Property

Unlike reinvesting the entire amount, you can choose the portion of the proceeds that will be reinvested to defer capital gains tax.

Retaining some of the proceeds may result in the immediate payment of capital gains tax on that portion. Careful consideration of the allocation is crucial to optimize your tax benefits in the 1031 exchange process.

6. Mind the Timeframe and Deadlines

There are two important time limits to remember.

  • Within 45 days of selling your property, you must identify potential replacement properties in writing and communicate this to the seller or qualified intermediary.

  • You must purchase the new property either within 180 days of selling your old property or before your tax return deadline, whichever comes earlier.

These timeframes ensure a successful 1031 exchange without incurring tax liabilities.

7. Exercise Caution Regarding Funds Handling

One crucial aspect of a 1031 exchange is being cautious about handling funds. Meeting the two deadlines is crucial to ensure the tax-deferred status of the gain from the property sale.

Remember that the core principle of a 1031 exchange is that if you receive proceeds from the sale, it becomes taxable income. Taking control of the cash or other proceeds before completing the exchange can disqualify the transaction and make the gain immediately taxable.

8. Report the Transaction to the IRS

To fulfill your tax obligations, you must include IRS Form 8824 when filing your tax return. This form serves to report your 1031 exchange transaction to the IRS. It requires you to:

  • provide information about the properties involved

  • outline the timeline of the exchange

  • specify the parties involved

  • detail the financial aspects of the transaction

Properly completing and submitting this form is crucial to ensure compliance with IRS regulations regarding 1031 exchanges.

A timeline graphic that illustrates the sequence of events in a 1031 exchange, with milestones marked at each step.

The 1031 Exchange Timeline

Here's the step-by-step process and key events involved in a 1031 tax-deferred exchange.

  1. Property under contract for relinquishment.

  2. Secure a qualified intermediary and enter into an exchange agreement.

  3. Assign sales contracts to the qualified intermediary.

  4. Complete property sale; proceeds held in short-term escrow.

  5. Transfer the title of the property being given up to the buyer.

  6. Within 45 days, find a maximum of three replacement properties and complete the settlement within 180 days.

  7. Agree to buy the new property by signing a contract.

  8. Assign a sales contract for the new property to the qualified intermediary.

  9. Close the replacement property within 180 days.

  10. Qualified intermediary transfers proceeds to the replacement property seller, with any remaining funds given to the exchanger, if applicable.

  11. The title was conveyed to the property owner from the seller of the replacement property.

Despite the strict guidelines and limitations of tax-deferred exchanges, utilizing this transaction can potentially provide substantial tax savings for investment and business property owners.

image of a property being exchanged, with arrows indicating the flow of funds and properties between the parties involved

How Does a 1031 Exchange Work From This Point?

Once you have a QI, you will list the property for sale. When it sells, the money temporarily goes to the intermediary. You have 45 days from the sale closing date to identify a property you wish to reinvest in. Failure to do so means you won’t qualify for a 1031 exchange.

Once you select a new investment property, you have 180 days to close the purchase. The exchange will be completed as the funds held by the QI (and any additional investment amount) are turned over to the seller of your new property.

Remember that the purchase price and your new loan amount, if any, must be the same or higher than on the property you relinquished.

Important Tips When Doing a 1031 Exchange

Here are some things to keep in mind when considering a 1031 exchange:

Understand the Deferral of Taxes, Not Elimination

A 1031 exchange does not eliminate capital gains tax but defers it. You must be aware that a capital gains tax liability will eventually arise, so it is crucial to be prepared for it.

Flexibility in Property Similarity

Flexibility in property exchange: "Like-kind" in a 1031 exchange doesn't require swapping identical properties; instead, it generally allows exchanging one investment property for another (consult a qualified tax professional before proceeding).

Time Constraints Require Diligence

When considering a 1031 exchange, time is of the essence as you have a 45-day window from the sale of the original property to determine a suitable replacement property for reinvesting the proceeds.

Limitations on Using 1031 Exchanges for Downsizing Investments

In 1031 exchanges, you must adhere to the stringent guidelines. These include acquiring a replacement property of equal or higher value than the one sold and utilizing the entire sale proceeds for the purchase to achieve a complete tax deferral.

An image of a calculator next to a growing stack of money

Why Use The 1031 Exchange Process?

The 1031 exchange process can be extremely beneficial financially, as it allows you to continue to exchange property and increase your net worth without having to pay capital gains taxes until it’s more advantageous to do so. There is no limit on the number of times you can be involved in a 1031 exchange.

This process has been an important tool for title companies, real estate professionals, and casual investors. At some point, you will want to cash out, and you will need to pay capital gains taxes in the tax year of your sale.

However, maximizing your investment in the meantime will allow you to maximize your additional gains. It is critical to understand the 1031 exchange process and the rules. Your QI can help you with this process and works to streamline it every step of the way.

An image of a group of professionals discussing real estate investments around a table

Discover the Ins and Outs of 1031 Exchange - Maximize Your Investment Potential

The process of a 1031 exchange can be intricate, involving specific rules, deadlines, and disclosure requirements. You must consult a qualified tax professional before attempting this type of transaction.

Precision Global is committed to being your reliable partner in projects aligning with your portfolio goals while providing valuable guidance for informed decision-making.

Get in touch with us today to explore whether you qualify for a 1031 Exchange and unlock potential benefits for your investments.

Professional Disclaimer:

Please note that Precision Global Corporation (PGC) is not a certified public accountant (CPA) firm, and the information provided in this article should not be considered professional tax advice. Content provided by PGC is for general informational purposes only.

Tax regulations vary by location and can change over time. It is recommended to consult with a qualified CPA or tax advisor who is knowledgeable about the specific tax laws applicable to your situation. They can provide personalized guidance tailored to your circumstances.

Precision Global Corporation does not accept liability for any actions taken based on the information presented in this article. For accurate and personalized tax advice, please consult a local CPA or tax professional.


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