How Does a 1031 Exchange Work?

Maryland Real Estate Podcast with Kathi Kershaw

A 1031 exchange allows you to transfer investment properties in a way that defers any capital gains taxes.

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Today we’re exploring the subject of 1031 exchanges and what you need to know about them.

I decided that this was a topic for an expert, so I brought in Carol Calomiris, managing attorney with the law firm Calomiris & Calomiris and settlement attorney with the company Settlement Pros, to answer these questions.

What is a 1031 exchange? Is it the same thing as a Starker exchange? The 1031 exchange (also called a “like-kind” exchange) and Starker exchanges are similar in the sense that they both involve the transferring of investment property in a way that defers any capital gains taxes. The 1031 exchange can be between two or three parties. The Starker exchange, on the other hand, is between three parties, where you have an additional intermediary between the two parties that are exchanging the property. Like-kind generally means the same character of property. In this case, it’s real estate for real estate. You can also sell a business and buy another business, but our scenarios would involve unimproved land being exchanged for a commercial building, or a condominium rental being exchanged for a single-family home

Is there a certain window of time to make the exchange? Yes. In order to qualify for the deferred capital gains tax, you would need to sell your property, and from the date of closing, you would have 45 days to identify the property that you want to exchange. That means you would have to look for and actually list by address the property that you are going to purchase with your exchange funds within 45 days. You then have 180 days from closing, meaning an additional 135 days to close on that new property.

Do you need a special kind of attorney to do the settlement? No. Any settlement company can do the closing for the sale of the property, but the important thing to know is that the seller doesn’t take control of the funds. In other words, the net proceeds from the sale of the property must go to a third-party (or intermediary). That company holds the funds until you find your replacement property and settle on it. When you find that replacement property and go to settlement, the intermediary would then take the funds from the sale of the property and forward it to another closing company that would then close on the purchase of your new property.

Any settlement company can do the closing for the sale of the property.

Can you exchange two inexpensive properties for one expensive property? Yes. The complexity, however, lies within the timing. You want to make sure you sell both properties and purchase the new one within the timelines allowed by the IRS so that you can defer the capital gains tax. The whole point of a 1031 exchange is to defer into the future the payment of the tax on the appreciable asset.

In addition to being an excellent attorney, Carol is also a wonderful counselor in all legal matters. If you need her help, you can call her at [phone] or visit her website at www.settlementpros.com.

If you have any questions for me or have another video topic in mind where I can bring in an expert to talk all about it, please feel free to shoot me an email or give me a call. I’d be happy to help!