What is a 1031 Exchange – Part Two
Last time, we covered how a real estate investor can qualify for a 1031 exchange strategy in order to defer from any capital gains they gain from swapping their investment properties. Today, we’ll go more in-depth into the complicated topic of 1031 exchanges by exploring the four types of exchanges an investor can perform in order for their 1031 exchange to remain valid.
Simultaneous Exchange: This style of exchange occurs when a relinquished property is swapped simultaneously for a like-kind replacement property. The simultaneous part speaks to the fact that the exchange must happen at the same time, meaning both properties must close on the same day/same time. There are three ways to perform a simultaneous exchange:
- Three Party Exchange: An accommodating party assists the investor with the exchange with another party. This method is generally not recommended as the accommodating party can be exposed to liability issues related to a property. NOTE: An accommodating party is not a qualified intermediary (QI) – a person who is qualified under certain IRC sections to undertake specific activities such as performing a simultaneous exchange.
- Two Party Trade/Swap: Two parties swap their investment properties with each other without a QI. However, it can be difficult to find like-kind property owned by someone who also wants your property and the lack of a QI introduces the possibilities of significant liability if the trade is not done correctly.
- Two or Three Party Exchange w/ QI: As the name indicates, two or three parties exchange with the help of a QI. A QI has been deemed as the only “safe harbor” in a simultaneous exchange and is typically an experienced professional. Note that there are also regulations towards whom you can use as a QI (hint, anyone you’ve had a previous agency relationship with, does not qualify!).
Delayed Exchanges: As one can assume, simultaneous exchanges can be hard to carry out and therefore the most common type of exchanges is a delayed exchange. Also known as starker or three-party exchanges, a QI is required in this process for the exchange to be valid. In this process, an investor must first sell their relinquished property(s). Proceeds from the sale are then transferred to a QI they’ve hired in a binding trust, then the investor has up to 45 days from the selling of his relinquished property(s) to identify three or more replacement properties (see identification period rules) and up to 180 days after the sale of the relinquished property(s) or their tax-filing date, whichever is sooner, to acquire the replacement property(s) with the help of the QI who uses the proceeds they received from the sale of the relinquished property to make the purchase necessary to close out the delayed exchange. The delay in the exchange gives the investor more time to prepare and to also identify like-kind properties which are why delayed exchanges have become so common.
Reverse Exchange (aka a forward exchange): A reverse exchange occurs when an investor first identifies/buys the property(s) they will acquire then identifies and sells the relinquished property(s), then has their QI purchase the replacement property(s) using the proceeds they received from their initial sale. The investor has up to 45 days to identify a relinquished property(s) and up to 180 days to sell the property(s). This form of exchange can be made tricker, as most banks won’t provide loans for reverse exchanges, so an investor may have to be ready to use all cash.
Construction Improvement Exchange: Our final form of exchange allows you to make improvements on the replacement property(s) using the equity you gain from the sale of your relinquished property(s). An investor will have to meet the following guidelines:
- All of the equity gained from the sale of your relinquished property(s) must be spent on completed improvements or as down payment by the 180th day while the property(s) is in the hands of a qualified intermediary.
- The investor must receive “substantially the same property(s)” that they had identified by the 45th day.
- The replacement property must be equal or greater in value when it is deeded back to the investor. The improvements must be in place before the investor can take the title back from the qualified intermediary.
It goes without saying, that 1031 exchange strategies can be very intricate. Knowing the regulations that qualify you for a 1031 exchange is just step one. An investor must also have the extensive knowledge of growing markets and choose replacement properties wisely as any depreciation in value can be a major setback and can leave you liable for taxes on any of the capital gains you made on your original properties. As we’ve mentioned before in our previous article, the information included in our guide is meant to be a stepping stone in the right direction. For any investors seriously considering this investment strategy, we highly recommend speaking to your broker who can recommend a professional such as a qualified intermediary to assist you with you further.