When listing a property for sale, there are few greater reliefs than finding a buyer who's prepared to purchase your property. When learning that the buyer plans to execute a 1031 exchange, several questions may immediately come to mind.
The most common concerns typically include, "How will this affect me as the seller?" and "Why is my buyer going this route?"
To create some context, let’s start with what a 1031 exchange is and why your buyer may be choosing this option.
Why is the buyer choosing to do a 1031 exchange in the first place?
When a property sells, sellers must pay capital gains tax on the amount that the property has appreciated. If you purchased a property for $600,000 and sold it for $900,000, you'd pay capital gains tax on that $300,000 increase.
However, when an investor enters into a 1031 exchange, they can defer (postpone) that capital gains tax. The federal government lets investors defer capital gains tax if they put the proceeds from the sale directly into another property.
According to the IRS, that second property must be "like-kind." That means it must be used for productive use in a trade, business, or investment and cannot be a personal residence that the investor inhabits.
An investor only has 45 days to identify that your property is the one they wish to purchase, so their time is extremely limited. From there, they then have 180 days to close on your property. So things will move quickly!
How will the 1031 exchange affect me as the seller?
For starters, you should include language in your contract specifying that there won't be an additional cost to you to work with a buyer in a 1031 exchange.
It's also important to note that when your buyer sells their original property, they're not allowed to hold the funds (referred to as "proceeds") that they'll use to purchase your home.
Even though it's technically the buyer's money, they must hire a third-party agent -- known as a qualified intermediary -- to hold the funds. When the time comes for the buyer to purchase your property, the qualified intermediary will send the funds to you and close the sale.
As a seller, you should have language included in your contract acknowledging that:
- you're aware of the buyer's intent to complete a 1031 exchange,
- you agree to cooperate at no additional cost or liability to you, and
- you're aware that the buyer has certain rights assigned to a third party (the qualified intermediary).
As the seller, can I enter into a 1031 exchange?
When working with a buyer in a 1031 exchange, you may find yourself wondering if you have the option to enter into a 1031 exchange as well.
If you want to execute a 1031 exchange, the property you plan to buy must be used for productive use in a trade, business, or investment -- it cannot be a personal residence. You'll also need to hire a qualified intermediary to hold the funds for your exchange.
As mentioned above, executing a 1031 exchange must happen within a very strict timeline. You have to identify the property you plan to buy within 45 days and close on that property in 180 days.
Not only will you defer capital gains tax, but you may also be able to defer all or some of any depreciation recapture tax liability. There's no limit to the number of 1031 exchanges you can perform. Under current federal estate tax law, you could defer gains indefinitely until the property passes to your heirs, who then receive a stepped-up cost basis. That negates a liability on years of capital gains.
The 1031 exchange is a popular and valuable tool used by many real estate investors. If you're a seller and your buyer is making an exchange, speak with your real estate agent about including specific language in your contract that states you're participating in the 1031 exchange.
Understanding the details involved in a 1031 exchange will not only be beneficial to you during the sales process but will also help you decide whether or not you want to execute an exchange as well.
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