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1031 Exchange for Dummies: What Is It and How Does It Work?


Investors in today’s market recognize the long-term benefits of selling and buying investment properties.

One disadvantage with this investment approach is the high capital gains taxes an investor pays on their property sale.

That’s why investors use a property exchange procedure that can significantly reduce their tax burden.

This procedure is called a 1031 tax exchange.

You can learn more about this investment approach in this “1031 exchange for dummies” guide and find out what you must do to initiate this procedure.

Grasp these 1031 exchange concepts and you’ll have a profitable business transaction.

1031 Exchange for Dummies: What’s a 1031 Exchange?

transfer of property

A 1031 tax exchange permits an investor to “transfer” their property sale profits to purchase more investment property.

The top benefit with this “transfer” is that the investor doesn’t pay capital gains tax on the profits received from the first property sale.

Investors won’t have to pay capital gains tax because the profits from their sale won’t ever touch their bank account.

The earnings go straight towards buying the second property.

Property buyers and sellers must complete a 1031 transaction within a certain time period after the first purchase to avoid a tax penalty.

The purchased property must have a higher or equal or higher purchase price compared to the sold property.

Buyers and sellers must not exchange any cash. There should also be no debt relief to circumvent paying extra taxes either.

“1031” corresponds with the section in the IRS tax law that allows these kinds of “transfers.”

1031 exchanges can only apply to commercial property or vacant land. 1031 rules don’t apply to exchanges on private dwellings.

What’s a 1031 Tax Exchange Company?

selling and buying new property

1031 exchange companies can oversee these complex sales between sellers and buyers.

1031 companies will sell your existing property and purchase any new real estate investments on your behalf.

They can also manage your sales profit and then direct it to your new property asset.

Section 1031 laws declare that a 1031 company can’t have any formal relationship with either the buyer or seller switching properties.

For example, siblings and parents can’t represent the seller or buyer involved in these acquisitions.

1031 tax exchange rules also state that attorneys or brokers can’t represent you if they were your agent on other transactions within the last two years.

1031 tax exchange companies area vital intermediary to help complete a 1031 exchange.

These companies can help sellers and buyers keep their distance from one another while they manage the property exchange.

Types of 1031 Exchanges

There are a number of different 1031 exchanges.

Each exchange has its own set of requirements for timing and procedures. These exchanges include:

Delayed Exchange

delayed exchange

1031 exchanges executed within 180 days are commonly known as delayed exchanges.

This format provides investors the most flexibility. Qualified intermediaries are necessary to complete these exchanges.

Build-to-Suit Exchange

Exchanges that permit a replacement property to undergo renovation or new construction is called a build-to-suit exchange.

All construction must be done within the same time frame as delayed exchanges.

Any construction done after that time won’t be included in the exchange.

Reverse 1031 Exchange

reverse exchange

If you buy a new investment property before you sell the property you want to be exchanged, you can do a reverse 1031 exchange.

The investment property is transferred to an exchange titleholder for 45 days.

This temporary hold gives you time to identify which property you want to be exchanged and 180 days to complete the deal.

1031 Tax Exchange Company Services

1031 exchange specialists can provide the following assistance:

  • Prepare escrow or title documentation for the replacement property as well as the sold parcel
  • Present this documentation, as well as detailed instructions to the title or escrow companies
  • Draft arms-length affidavit materials. These documents confirm that there is no pre-existing relationship between the buyer and the seller. These documents also confirm that there no pre-existing relationship between the property owners and 1031 exchange company
  • Transfer the sold property conveyance to the new owners on the seller’s behalf
  • Oversee any sales proceeds from the sold property and make deposits into an insured and separate account
  • Collects sales data on similar, potential properties for their clients
  • Delivers sales earnings to purchase the new investment property. They also transfer these earnings to the escrow or title company to conclude the sale.

You can find out more on this website about the services a 1031 exchange company can do for you.

How to Shop for a 1031 Exchange Company

agent explaining about complicated transaction

There are specific qualities you should look for if you’re hiring a 1031 exchange company to represent you.

These companies should be able to help you reach the milestones within every 1031 exchange timeline.

Look for an agent that can explain the advantages and disadvantages of these complicated transactions.

Find 1031 exchange companies that offer services nationwide.

Since the federal government regulates a 1031 exchange, it’s important that these nationwide companies perform consistently throughout each of their locations.

You will be guaranteed consistent service no matter where the sale takes place.

Look for insured and bonded exchange companies.

The best company to hire will be the one who proves that they will safeguard your hard-earned money.

When you interview a 1031 exchange company representative, ask to see a copy of any fidelity insurance declarations they might have.

You should also ask to see a copy of their errors and omissions insurance declaration.

Then you will be assured that your investments are protected against fraud and negligence.

Next Steps

Do some research before you interview a 1031 exchange agent to represent your transaction.

Read up on the 1031 tax exchange laws so that you are aware of your obligations.

Ask your friends and family members for recommendations on these specialists.

You can also ask your local escrow officer for their recommendations.

They might have an opinion on which 1031 company can manage your transaction best.

You can find more real estate information on our website that can enhance your “1031 exchange for dummies” level of knowledge.

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