1031 Exchange Rules and Requirements: What Is It? How Does It Work?

In today’s investment environment, an investor knows all about the many perks of buying and selling investment properties. The downside to this strategy is the high capital gains taxes investors will have to pay for their property sales. Sometimes an investor uses an investment process known as a 1031 exchange that helps reduce these tax burdens.

Are you new to real estate investments? If you are, then find out here what you need to know about a 1031 exchange. You’ll discover some built-in benefits that can reduce your tax burden and how a real estate professional can help you through this process.

What is a 1031 Exchange?

1031 exchange happens when investors sell their property and “trade” their profits from this first sale. The goal is to buy more investment property. The benefit to this kind of “trade” is that sellers won’t pay capital gains tax on these sales because the funds won’t reach their bank account. All profits go towards buying another piece of property.

Both property buyers and sellers must complete these transactions within 180 days of that first sale to avoid any tax penalties. The sold property must be at a higher or equal price than the purchased property. There shouldn’t be any debt relief and no funds should be exchanged to avoid additional taxes.

The 1031 exchange gets its name from the US Internal Revenue Code, section 1031. This section of the code states that these exchanges can only apply to commercial properties or vacant land. They can’t apply to someone’s home residence. Therefore, this process can be an attractive way for investors to build their rental portfolios.

What are 1031 Tax Exchange Companies?

1031 tax exchange companies facilitate the sales between sellers and buyers. These companies can buy new properties on your behalf as well as sell your existing inventory. These companies will also hold your sale proceeds and then transfer them to your next new property transaction.

Section 1031 exchange rules prohibit a 1031 company from having a formal relationship with either buyers or sellers who are exchanging their properties. For example, a sibling or parent can’t represent a buyer or seller involved with these exchanges.

The 1031 exchange requirements also say that neither a broker nor a lawyer can represent you if they represented you on any of your other transactions within the previous two years. A 1031 company can help both buyers and sellers maintain their distance from each other while they negotiate the exchange transaction.

Other services that a 1031 tax exchange company can provide includes:

  • Drafting any necessary documents that apply to the sold and replacement properties; delivering necessary documentation and specific instructions to the escrow or title companies; Coordinating with buyers and sellers on the final arrangements.
  • Drafting an arms-length affidavit between property buyers and sellers. An arms-length affidavit is between the property buyer and seller. These affidavits confirm that there is no pre-existing relationship between a buyer and a seller. These documents can also confirm that there are no pre-existing relationships between the property owners nor the 1031 exchange company.
  • Delivering a seller’s sold property conveyance to any new property owners.
  • Managing the sale proceeds of the sold property and deposit them into any separate accounts during the property escrow period.
  • Collecting sales information on, similar eligible properties for their clients.
  • Distributing any stored sales revenue to purchase new properties. They can also deliver these sales revenues to the escrow or title company to finish the sale.
  • Accepting a property deed or title for the seller’s replacement property.
  • Drafting detailed reports that describe the 1031 exchange transaction for both the buyer and seller. The 1031 tax exchange rules specify what details you should include in this particular document.
  • Transmitting all 1099 forms that outline what non-personal income the seller received throughout the previous year. A 1031 exchange company can also prepare any other required legal documents that fulfill the guidelines from the IRS.

What You Want in a 1031 Exchange Company

There are specific abilities you will want when you’re ready to hire a 1031 exchange company to represent you. A 1031 company must be ready to tell you what the advantages and disadvantages are for these complex transactions. Be on the lookout for those professionals that are willing to share their perspectives and experiences.

You should find a 1031 exchange company that can offer its services nationwide. It’s important that these nationwide offices offer consistent performance in all locations because the federal government oversees them. Then you’ll be guaranteed a “by the book” process regardless of what state the sale occurs.

You should also find a bonded and insured exchange company. These companies are used to showing clients that they are prepared to protect your investment.

When you interview a prospective 1031 exchange company, request proof of their fidelity insurance declaration. You should also request to see a copy of their proof of errors and omissions insurance. Then you’ll know that your investments are safe against fraud or negligence.

Other services you should look at when you’re considering these representatives might include:

  • Services offered along with 1031 exchanges.
  • Industry experience.
  • Customer service contact information.

What Are Your Best Next Steps?

Do some homework before you start meeting with companies that can represent you. Study the 1031 exchange process and read up on any applicable IRS rules. You can also quiz your friends and family members for possible referrals.

When you do meet with an exchange company representative, ask them to show you their statement of errors and omissions insurance. Ask them for proof of their fidelity insurance. If these companies can show you these documents, you’ll know that your investments can be protected against fraud or negligence.

Still not sure about real estate investing? Then head on over to our website for more on the advantages and disadvantages of investing in commercial real estate. At GoKapital, we’re here to help you succeed with your real estate investment dreams!

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