A 1031 exchange is a tax strategy used to defer capital gains taxes from the sale of investment or business real estate. The most common exchange I see in my marketplace is one rental property for another. Other exchanges I see are a rental property for a commercial property or a rental property for qualifying DSTs.
Plan ahead of time! If you are even thinking of selling a rental property, I recommend talking to a 1031 exchange specialist to see if this is something that could benefit you. You don’t want to be hit with a huge capital gains bill because you did not follow the rules of the exchange properly.
Additionally you have to have a qualified intermediary in place before the sale of your relinquished property closes. You don’t have to choose an intermediary before you come on the market, but you will have less of a headache if you work with a trusted qualified intermediary from start to finish. It’s also worth noting that you cannot receive the funds of a sale directly from escrow. They have to go through the intermediary or you might not be able to defer the capital gains from your sale.
Lastly, if you are selling rental property, I would recommend talking to a real estate agent. We will start searching for your qualified replacement property while your current property is on the market. This increases your chances of meeting the 45-day deadline to identify the exchange property. Additionally, you will feel less pressure to have a property identified within the 45-day deadline. We can even write offers subject to the close of your rental property. It’s always better to have the most options.
Here’s a real-life example of how a 1031 exchange can make sense beyond the tax benefits.
A client of ours inherited a rental property from their parents. The property was located in the East Bay. They completed their parents’ Trust, and they were officially the owners of the rental property. After a year or two, they found that being landlords who lived across the Bay was too much work for them. They were in their 60s and spending 3 hours driving across the San Mateo Bridge every month to collect the quarters from the laundry machine or coordinating an emergency plumber at 12am was too much work for them! They wanted to enjoy life. But they were both retired, and they enjoyed collecting rental income to help fund their love of traveling. They just wanted to own a rental property that was easier to manage. We found them a lovely duplex near Downtown San Mateo that they were able to exchange into well within the 180-day deadline to close. It was about 5 miles from their house in Belmont which made property management much easier for them to manage on their own.
I’m not a professional 1031 Exchange intermediary or a tax preparer. I’m just sharing my personal experience in the hopes that you find it helpful! For additional information, I really like the article from Investopedia giving a basic explanation of what a 1031 Exchange is. I also recommend Ron Richard at IPX 1031 Exchange. He is always happy to answer any questions you might have to decide whether or not a 1031 Exchange is the right move for you.