Investors in the market today know about the long-term benefits of buying and selling investment properties. One disadvantage to this investment strategy is the high capital gains tax investors pay from their sales. That’s why you’ll see investors use a system of property exchanges that can cut their tax burden.
This system is a 1031 tax exchange. Check out this “1031 exchange for dummies” guide and find out what you’ll need to launch this process. Master these 1031 exchange basics to guarantee a successful transaction.
1031 Exchange Basics: What Is a 1031 Exchange?
A 1031 tax exchange allows investors to “transfer” their profits to buy another separate investment property. “1031” coincides with the IRS tax code section. The main advantage of this “transfer” is that the investor won’t have to pay capital gains tax on the profits they received from their individual sale.
Investors don’t pay capital gains tax because the proceeds from their sale don’t reach their bank account. The proceeds go to purchasing the second property.
Property sellers and buyers need to complete these transactions inside 180 days after the first sale to avoid tax penalties. The sold property should have an equal or higher value compared to the purchased property. Sellers and buyers can’t exchange any cash and there shouldn’t be any debt relief to avoid extra taxes.
1031 transactions take their name after Section 1031 of the US Internal Revenue Code that outlines these 1031 tax exchange rules. 1031 exchanges only apply to vacant land or commercial property. 1031 rules exclude exchanges on private homes.
What Is a 1031 Tax Exchange Company?
1031 tax exchange companies can manage these complicated sales between buyers and sellers. A 1031 company can sell your existing property and buy any new property on your behalf. They can also hang onto your sales earnings and then direct them to your new property acquisition.
Section 1031 rules state that 1031 companies can’t have formal relationships with either a seller or buyer exchanging properties. For example, parents and siblings can’t represent buyers or sellers involved in these exchanges.
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.
Services Provided by 1031 Tax Exchange Companies
1031 exchange specialists can provide you the following services:
- Tell sellers and buyers about the format of a 1031 exchange
- Drafts necessary documentation relating to the sold property as well as the replacement property
- Presents this documentation, as well as detailed instructions to the title or escrow companies
- Prepare an arms-length affidavit. This affidavit is between a property seller and buyer
- The affidavit verifies that no pre-existing relationship exists between the seller and the buyer. These affidavits also certify that there is no pre-existing relationship between the 1031 exchange company and any of the property owners
- Transmits conveyance of the sold property to the new owner on the seller’s behalf
- Manages the sales proceeds from the sold property and deposits them into a separate and insured account
- Maintains any sale proceeds from the sold property during the 45-day escrow identification period
- Gathers sales information on potential, similar properties for their buying clients
- Distributes the stored sales proceeds to buy the new property. Transmits these proceeds to the title or escrow company to complete the sale
- Accepts the property title or deed of the seller’s replacement property
- Writes a detailed accounting report describing the 1031 exchange for both the seller and the buyer. 1031 tax exchange rules outline specific factors that you need to include in this accounting report
- Prepares any appropriate 1099 forms necessary to identify any income a seller received outside of their regular salary. The 1099 form also reports any paid growth earnings or interest earned as well. 1031 exchange agents also prepare any legal documents necessary to fulfill IRS guidelines for like-kind property sales.
Qualities to Seek in a 1031 Exchange Company
There are qualifications you should look for when you’re hiring a 1031 exchange company to represent your transaction. These companies should be well versed in the benefits and disadvantages of these complex transactions. Look for those transparent agents that are generous with their experience and perspectives.
Look for a 1031 exchange company that offers their services nationwide. Since the federal government oversees these exchanges, it’s vital that these nationwide offices performance is consistent throughout each location. That way, you’re guaranteed a uniform, “by the book” process no matter where your sale takes place.
Look for bonded and insured exchange companies. The top companies to hire are those who can prove that they can protect your hard-earned money.
When you do interview a 1031 exchange company agent, ask them to show you a copy of their fidelity insurance declaration. You can also ask them to show you proof of their errors and omissions insurance. That way you’ll feel safe in knowing that you have investments protected against negligence or fraud.
Other factors to consider when hiring these representatives include:
- Services offered along with 1031 exchanges
- Fees for 1031 exchange services offered
- Accessible customer service contact information
- Industry experience
Next Steps
Do your homework first before you meet with a 1031 exchange specialist to represent you. Research 1031 tax exchange rules to become familiar with your obligations.
Ask your family members or friends for referrals to these professionals. You should also inquire with a local escrow officer for their referrals as well. They might have opinions on which company can represent your transaction the best.
If you want to know more about the 1031 exchange basics, don’t forget to keep browsing our blog. We have plenty of posts that discuss topics like investing, stock trading and unit investment trust funds. We hope you enjoy reading and learning about personal finance!