8 Key Steps in the 1031 Exchange Process by Austin Bowlin, CPA – Partner at Real Estate Transition Solutions
Paying taxes on the sale of rental property can be very expensive. In some states, the total amount of tax can be as high as 42.1%. That is why many property owners utilize a 1031 Exchange to defer, reduce, and even eliminate taxes related to the sale of investment property.
Intermediary (QI) before closing on the sale of the relinquished property.
With a 1031 Exchange, rental property owners can sell their existing investment property and defer paying capital gains tax if the proceeds are reinvested in another investment property of equal or greater value. Additionally, for many investment property owners, a 1031 Exchange also allows for a transition to passive management while improving monthly income potential and diversifying their real estate investments.
• The Exchanger has 45 days from the sale date of their relinquished property to identify their replacement properties.
However, the 1031 Exchange process can be complex and stressful. IRS exchange rules are very rigid, and the 1031 Exchange timeline must be strictly followed to qualify for tax deferral. That is why we make sure our clients understand 8 key steps in the 1031 Exchange process before listing a property for sale. Step 1: Calculate Your Gains Tax Liability Calculating the tax liability on the property you are selling is generally the first step in the Exchange process. Property owners can pay up to 42.1% in taxes related to the sale of their investment property depending upon the state the property is located and the amount of taxable gains – net proceeds less the original tax basis. The taxes applied to taxable gains are as follows: • • • •
Federal Capital Gains Tax: 15% – 20% State Capital Gains Tax: 0% – 13.3% Depreciation Recapture Tax: 25% Net Investment Income: 0% – 3.8%
Step 2: Understand 1031 Basics, Rules & Timing Requirements To help ensure your 1031 Exchange is successful, it is critically important to have a basic understanding of how exchanges work, IRS rules, and timing requirements that must be followed to qualify. Here are 8 key rules that apply to every 1031 Exchange. • The Exchange must be for “like-kind” investment property that is held for use in trade or business or for investment. •
The Exchange must be set up with a Qualified 6
RENTAL ALLIANCE UPDATE November 2021
• The legal ownership entity on the title of the relinquished property must also acquire the replacement property (must be the same legal entity).
• Following the close of the sale of their relinquished property, the Exchanger has 180 days to close on the sale of their replacement property. • The Exchanger may identify up to three replacement properties. The aggregate value of the properties identified may not exceed 200% of the value of the relinquished property. The Exchanger may identify any number of properties with any aggregate value but must close on 95% of the aggregate value of the replacement properties. • The replacement property’s value must be equal to or greater than the relinquished property. All equity resulting from the sale must be used. • Exchangers cannot take possession of their Exchange funds. Step 3: Set Financial & Lifestyle Objectives for Your Exchange Setting financial and lifestyle objectives is another critical first step with every 1031 Exchange. These objectives should be based on what you are looking to accomplish today and well into the future. Identifying and selecting replacement properties should be based on key objectives including lifestyle, risk tolerance, cash flow, and appreciation goals, liquidity, desire for management control, debt considerations, and estate planning needs. Setting objectives is critical in developing the right 1031 Exchange strategy. Step 4: Assess 1031 Replacement Property Options Identifying suitable replacement property can be a challenging and stressful process. Therefore, we recommend assessing potential replacement properties before listing your relinquished property. Several factors must be carefully considered when seeking to align your financial and lifestyle goals with the right ownership structure, locations, property (continued on page 7) www.rhaoregon.org
