I just did a 1031 exchange by myself having never done one without needing to pay the $1000 that the 1031 company wanted to charge me. I'm not a lawyer, just a normal guy. Here is what I learned:
1031 Requirements: Download the actual IRS 1031 fact sheet here:
Facts: 1031 Exchanges are NOT super complex as 1031 companies claim so they can overcharge you. 1031 companies are only needed in the event you don’t sell and buy at the relatively same time (as long as the title company you are using to buy the upgraded property is willing to hold it) because of two IRS rules.
Rule 1: You can’t receive proceeds into a personal account from a sale before it goes into the new property, it must go direct from old property to new property, from title company to title company.
Rule 2: You can’t own the title of the new property and old property at the same time. If you don't sell the old property BEFORE or up to the same day of the new property (simultaneously) then another unrelated person, group or entity for your protection (LLC) needs to hold it for you until you can sell the old property.
The rest of the requirements are not complex at all: The tax basis determination and the tax reporting form are not difficult.
Qualification for 1031 Like-kind exchange: Owner of investment property (can’t use personal property)
3 Structures (Types of 1031s): 1) Simultaneous, 2) Deferred, or 3) Reverse exchange. In all scenarios you have one or more “relinquished” proper(ies) that you trade up for one or more “replacement” propert(ies). For simplicity going forward, I’m going to call the “relinquished” property the “old” property and the “replacement” property the “new” property.
1-Simultaneous exchange happens when you sell the old property at the same time as purchase the new property. This is the simplest structure and doesn’t require any 3rd party but 1031 companies will not tell you that, they will gladly take your $1000. Not specifically required, but for good measure, just send out a signed notification letter to the seller of the new property officially identifying the old and new properties with the intent to to the exchange and then arrange for the "old" properties title company to send the money to the "new" properties title company (or just notify them of the 1031 if you are using the same title company). That is the key, just ensure the proceeds that you want to use from the old sale go from title company direct to the new property because “taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable”. Keep a record of the wire transfer for any future audit and on your next tax return fill out IRS form 8824 in your tax software or separately. That’s it. That is all the IRS cares about. They have an issue with any of the taxable proceeds that you plan on using in the exchange going into a personal account where you can use it for something other than real estate to include accruing interest on it etc before it goes into the new property. Why they care? I don't know, my guess is that someone did some shady money laundering at some point and this is how they prevent it. Pretty dumb rule in my opinion, but the IRS is known for those.
2- Deferred Exchange is the most common structure as it can be challenging to arrange the sale and purchase of the different properties simultaneously so you need somewhere to send the money other than your personal account. It is called “deferred” because you sell the “old” property first and then purchase the “new” property at a later date but within the deadline of 6 months. The added complexity with deferred is that you do need a place to send your money in between transactions. You can’t just send it to a friend though, it needs to be what they call a “qualified intermediary” (QI) to hold on to the proceeds from the old property sale until you can move them into the new property. A QI is a 3rd party facilitator unrelated to you, your family, or other business interest that can hold onto the money temporarily for you so it doesn’t touch your personal accounts before it gets put into the new property. You also can not act as your own facilitator, which is just a frustratingly dumb rule. Again, the only thing that should matter in my opinion is the timeline and proper accounting for tax basis moving from the old to new property. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator. It has to be a 3rd party. A lot of title companies do it or have someone on staff that handles these exchanges or you can find a hundred options online. Also, a quick search on the internet will bring up plethora of 1031 companies that offer QI service. They write up the agreement to hold onto and protect your money and give it back when you close on the new property. As such, they get keep all the interest off your money until they turn it back over to you and you pay them $500 to $1500 usually for the privilege. In the mean time you hope they don’t go bankrupt while holding your money thereby forcing you beyond the 6 month exchange window - probably not common but has certainly happened. There is always risk in letting anyone use your money. For this reason, if you need to us a QI, I'd recommend going with one attached to a reputable title company.
3- Reverse exchange - Purchase the new property first and then sell the old property after that, thus the “reverse”. This is the most pricey option as you will need a QI to help you set up a “qualified exchange accommodation agreement” that is established by an “exchange accommodation titleholder (EAT) which is a bunch of big words meaning they will set up an independent LLC that will hold the new property’s title (Rule 2: you can’t own it at the same time that you still own the old property’s title). Most 1031 companies will charge you $8k -$10k to do this. To put this in perspective, LLCs in most states are really easy and cheap to establish by yourself no lawyer needed. The problem is that it needs to be the QI's LLC so they will need to do it for you and they will charge you a lot to do this. They also create all the paperwork/agreements you need to establish rules for the title exchanges, leasing back to you while the title is held by the LLC, rental agreements if you have tenants etc. So more complex than a deferred exchange, but to charge $8k for a few hours of service using largely cookie cutter forms/paperwork is almost as bad as what realtors charge for the privilege of walking you through homes and forcing you into largely single sided agreements, but I digress. All that said, paying 8-10k could save you $10s of thousands if not $100s of thousands in taxes depending on how much principle you were able to pull out of your sale so even at $8-10k, it still might be worth it. As for the time restraint to complete the exchange, it is the same 6 month rule, you need to sell the old property before 6 months after purchasing the new property. Fail to sell? The 1031 company keeps your $10k regardless.
More on 1031 Companies/Services:
The companies that advertise 1031 services claim the process is just too complex for anyone but lawyers to understand and fear monger you into thinking the penning of basic notification letters, a single IRS form, calculating your tax basis and following a few deadlines is so complex that you need a law degree to successfully avoid the IRS swooping in and charging you full capital gains tax and claiming your first born child. The truth is, as you will read below, a high school student can follow the requirements. They will even try to charge the $%00 - $1500 for a simple simultaneous exchange.
That said, where 1031 companies do offer value that can’t be done by your self or anyone you personally know or work with is to act as a QI that will hold onto your money or hold onto your title in an LLC while you are trying to sell or purchase the other property. So if you can’t set up your sales to ensure a simultaneous exchange, you may just need to bite the bullet and pay for a QI 1031 service. If that is the case, be sure to shop around for the best deal while dodging scams. A safe bet is using one tied to your title company, I’ve found that most title company has someone that does 1031s. Alternatively, you can risk it for a cheaper alternative online, but remember, they will be the ones holding onto your money or title so choose wisely.
What Property qualifies for 1031 Exchanges:
Properties need to be held for use in business or investment, no personal properties or primary residences. For instance you can’t do a 1031 from a rental property into a new primary residence for yourself, though you can move it from a rental to a rental, rent it for 2 years (no actual timeline is specified by the IRS but most everyone agrees that 2 years is safe). Anytime after 2 years, you can then move into it and claim it as your primary residence after those two years and get the tax benefits of primary residence as long as you have lived there for at least two years and sell before 5 years if you leave and start renting again.
Both properties must be similar enough to qualify as “like-kind”, or same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.
Time limits (Applies to deferred or reverse exchanges where you have a gap between transactions): For a deferred exchange, the first deadline is 45 days from date of sale of old or purchase of the new property, you need to identify in writing (identification letter) signed by you and delivered to a person involved in the exchange such as the seller of the new property or your QI. Must be the owner or QI, not anyone else such as an agent. If you are using a loan for the new property, you’ll want to let your loan officer know too in case they might see a complication with loan requirements, but this isn’t required by the IRS.
Contents of written identification letter for deferred exchange:
Date
Name of Seller or QI that you are addressing and their address and phone number
Content: “This letter serves as notification of intent to use the following investment properties in a deferred 1031 like-kind exchange and is within the 45 day identification requirement. The properties to be exchanged include the following:
Relinquished Property, sold on XX date:
100 Main St
Normal, IL 12345
Replacement Property:
200 Main St
Normal, IL 12345
Your signature block, address, and Signature
Be sure that replacement property is clearly described to include the property’s legal description, street address or distinguishable name. While not explicitly required, you can throw in the lot number or any other identifying information. The IRS just needs the specific address so it can’t be misconstrued or manipulated later into a different address. Be sure to check with the seller to ensure they received it, whether scanned and sent via email or regular mail. The time stamp can help prove timeline in the unlikely event of an auditor who questions the dates in your letter.
Calculate the basis of the New Property:
The 1031 exchange defers capital gains tax, not eliminate it, so you need to calculate the "basis" in the new property. Here are some links for different scenarios, if you aren’t comfortable doing tax calculations, get with a tax expert to help you determine the new basis but it isn’t very complicated, in general here is the basic formula: Proceeds from sale minus what you bought it for plus any improvements you haven’t already claimed in other tax years minus any depreciation.
Using the links above, you can determine how much is subject to capital gains and whatever that amount is will lower the tax basis in your new property. For instance, if you had a profit of $200 over what you paid for the old house, the amount subject to capital gains in the old home is $200K. If you decide to use all $200K in the exchange toward a down payment on a new $500k property then your tax basis is $300k rather than the purchase price of $500k. In other words, the higher the basis, the less tax you pay when you sell it, so your tax burden is still there but you get the benefit of potentially never paying it as long as you don't ever sell again or keep exchanging your old properties into new investment properties indefinitely.
Final Step - File IRS form 8824 “like-kind exchanges” on your next tax return.
What you need to fill the form, make sure you get all this info so you can fill out the form. You could just fill it out at the time of sale and then add it to your return if you do returns yourself or just give it to the company that does your taxes:
• Descriptions of the properties exchanged (Addresses and type of investment property)
• Dates that properties were identified and transferred
• Any relationship between the parties to the exchange
• Value of the like-kind and other property received
• Gain or loss on sale of other (non-like-kind) property given up
• Cash received or paid; liabilities relieved or assumed
• Adjusted basis of like-kind property given up; realized gain
So again, you can see, not rocket science, they just want basic information. All of the 1031 companies do is act as QIs to hold your proceeds or title until you can finish the exchange and charge you quite a lot to do it.
Good luck!