Timing Matters: Know the Milestones for a Successful 1031 Exchange

A 1031 exchange can make it possible for your clients to defer taxes on the sale of a property by exchanging it for another like-kind property of equal or greater value. This tactic can help them keep more of their capital working for them while preserving their real estate portfolio exposure.

But in an effort to reap the benefits of a 1031, your clients must adhere to a strict timeline. Failure to follow the rules attached to 1031s could result in the IRS disallowing the transaction — which could add up to a hefty capital gains tax bill and missed opportunity.

It’s a manageable process if you know what to expect. Here are the essential steps and rules to know if your clients are considering a 1031 exchange.

Selling existing property and finding a qualified intermediary

Before your client decides to pursue a 1031 exchange as part of their investing strategy, you’ll want to make sure their property qualifies. It must be a property they hold for investment purposes, and your client must have held it for at least two years. That two-year timeframe matters on the other side of the transaction, too: They must hold the new property they acquire in the exchange for at least two years as well.

“1031 exchanges are not for investors who are out there buying and flipping,” says Rob Johnson, head of wealth management for investment property management firm Realized. “They are for long-term investors who have a plan.”

To begin a 1031 exchange, the real estate investor enters into a contract to sell their existing property. Then, you and your client should select a qualified intermediary (QI)—an independent person or company who will produce a written agreement that facilitates the exchange and hold the funds from the initial sale, similar to an escrow.

This selection should take place at least three weeks before the close date of the property your client is relinquishing so the QI can set up the exchange. “It’s important that the intermediary is a well-established firm with a good track record in the space,” Johnson says.

Identifying a replacement property

From the day your client’s relinquished property closes, they have 45 days to identify potential replacement properties of equal or greater value. It’s best, though, if your client has already identified the property (or real estate investment vehicle) they’re interested in before closing on the sale of the property they’re letting go of. “It’s probably not a good idea for your client to do a 1031 exchange if they don’t know what they’re going to buy,” Johnson says.

Identification of the replacement property must be delivered in writing to the qualified intermediary by midnight of the 45th day after closing of the relinquished property. But “replacement property” has a few permutations. It can be:

1. up to three properties of any value;
2. any number of properties, as long as the total combined value doesn’t exceed 200% of the fair market value of the relinquished property; or
3. more than three properties whose combined value exceeds 200% of the value of the relinquished property, as long as your client acquires at least 95% of the total value of the properties.

Remember that if the sale price of the relinquished property is greater than the price of the replacement property or properties, the difference must be recognized as a capital gain.

Identification forms can be rescinded by midnight of the 45th day after closing on the relinquished property if your client decides they’re no longer interested in a property. If more than 45 days have passed, however, any remaining exchange funds will be locked in the exchange account until 180 days have passed.

Considering a DST

For clients no longer interested in owning direct real estate, they can swap a directly owned property for a Delaware Statutory Trust, or DST. A DST is a legal entity that gives accredited investors a fractional interest in a trust that owns real estate. DSTs allow for hands-off real-estate investment without the complications that come with managing property directly. They can also provide an opportunity for diversifying your client’s real estate investments, along with reduced tax liability for tenant improvements or debt service.

As is the case with all types of real estate investments, not every DST will be right for every client, so it’s important to identify the DST or DSTs that best align with your client’s goals before or during the 45-day period that begins after your client closes the sale of their relinquished property. And the sooner the DST is secured, the better. “Real estate is not evergreen,” Johnson says. “Some of the best DST options fill up very fast. We’ve seen some fill up within 24 hours.”

Closing on a 1031 exchange replacement property

Once your client has closed the sale of the relinquished property, they have 180 days to close on the property or properties they’ve identified. In other words, your client has 135 days after the 45-day identification ends to close the purchase. Note that if the exchange extends from one calendar year to the next, your client should file a tax extension so that taxes are completed after the exchange has happened.

It’s clear that 1031 exchanges have some very specific requirements and managing the timing of one requires everyone involved to stay clear about the timing for each step. And it can be worth it—executing a 1031 exchange properly can help your client keep more of their investment property wealth working for them. They may be able to defer taxes on the sale of a property and exchange it for a share in a passive investment vehicle that seeks to deliver passive income, such as a DST. When you work with clients who might be interested in a 1031, start strategizing well before the process begins so you can plan every step together.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.