1031 Exchange Guide
Oklahoma real estate has become a top target for investors seeking 1031 exchange properties. In particular, most Oklahoma or out-of-state investors look for NNN properties (known as “triple-net” properties) which allow for a version of somewhat more passive ownership.
This article provides a brief overview of the 1031 process and relevant details for investing in real estate through the 1031 tax deferred exchange, which is available in Oklahoma and all other states under section 1031 of the internal revenue code (IRC).
If you have questions about the process, or need representation in a 1031 exchange process from attorneys who have the necessary experience, contact Avenue Legal Group today.
What is a 1031 exchange?
A “1031 exchange” is a type of real estate transaction where the IRS has allowed no gain or loss to be recognized if the property sold is exchanged solely for a property of like kind. That means a 1031 exchange is an exception to the general rule that sellers have to pay a tax on the gain in value of the property being sold (“capital gains”). The tax which does not have to be paid at the time of the first property sale is deferred – you don’t get to avoid taxation, but you can defer the payment of the tax indefinitely. Investors utilizing the 1031 tax-deferred exchange strategy must be held for investment or business purposes.
There are generally two structures to an 1031 exchange.
The first structure is a simultaneous swap of one property for another. This allows a very quick closing process and the investor is certain to avoid issues related to the deferred structure’s timelines. The second structure is a deferred exchange (which can be more common in a fast-moving market), allowing flexibility for the investor but utilizes exchange facilitators, including qualified intermediaries (QIs) and has a more strict timeline where tax penalties can be imposed if the replacement property sale has issues closing.
Since the deferred exchange process can be more complicated, how does the deferred process work?
- You sell the original property.
- You give the original property sale proceeds to a qualified intermediary (QI), who holds the funds in a protected account, which includes the real estate sales tax you would have paid on the sale. This step is very important, as the investor making the exchange cannot take receipt of the funds from the first sale.
- You work with your QI and other real estate agents or brokers to find like-kind replacement properties. The “three property rule” kicks in, where you should generally identify at least three like-kind properties which could be acquired in the second part of the exchange. There are additional rules, such as the “200% rule” and the “95% rule” which should be followed as well. The importance of working with an experienced team in order to follow these rules cannot be overstated.
- You identify a suitable like-kind replacement property within 45 days of closing on your original property sale.
- You work with a real estate attorney, agent, and your QI to get a replacement property under contract. This will likely require a custom or specifically drafted letter of intent (LOI), purchase and sale agreement (PSA), agreement on earnest money, decisions on title-holding entities such as trusts or LLCs, and more.
- You conduct due diligence to ensure the replacement property is worth the investment.
- You close on the purchase of the replacement property within 180 days of the original property closing to effectively defer the federal property sales tax and capital gains from the original property.
What types of properties can you use in a 1031 exchange?
Most 1031 investors seek NNN tenants via commercial properties. However, it is possible to exchange for residential properties. The base-level rule for replacement properties is that the transaction must be an arms-length transaction (i.e. you cannot have a close business relationship with the seller of the like-kind replacement property).
Can I aggregate multiple properties into one property?
Yes – it may be possible for investors to sell multiple original properties and exchange “up” into a single property with a higher value.
Can I sell one larger property and invest in multiple smaller properties?
Yes – it may also be possible for investors to sell one higher value property and exchange “down” in single asset value to multiple lower value assets to form a pool of investment properties.
What are the 1031 exchange deadlines?
These deadlines will apply to a deferred exchange, rather than a simultaneous swap exchange. Suitable replacement properties must be identified within 45 days of the original property sale closing. The acquisition of the replacement property must be completed (closed) within 180 days of the original property sale closing.
What if I already bought the replacement property?
A “reverse exchange” may be possible for investors who already acquired a replacement property before closing the sale of their original property. Timelines and additional requirements (such as an exchange accommodation titleholder) apply.
Can I avoid property sales tax?
A 1031 exchange is a tax deferral strategy, rather than a tax avoidance strategy. However, the deferral can be extended indefinitely through buy and hold strategies, or repeated successive exchanges.
Do I need a custom contract for a 1031 exchange?
A contract specifically drafted for your particular transaction is highly recommended. The attorneys at Avenue Legal Group have the right experience to effectively protect the interests of both buyers and sellers throughout any 1031 exchange transaction – including carefully crafted and thoughtfully negotiated purchase and sale agreements (PSA).
Should I use an LLC in a 1031 exchange?
We strongly encourage investors to use limited liability companies (LLC) or other limited liability entities whenever possible as a shield for legal liability of the owners, members, and operators. LLCs, partnerships, C-corporations, S-corporations, private trusts, and many various entity types can be a party to a 1031 exchange. See our article on Oklahoma LLCs here.
What happens if my seller backs out of the transaction leaving me not enough time to close on a replacement property?
There may be some quick and effective options available to investors who have suddenly found themselves without a property to acquire within the 180 day deadline. A well-known example would be a Delaware Statutory Trust (DST) which can be available to accredited investors in all states (not just Delaware); this is a type of real estate portfolio which is registered with the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA). However, it is important to not wait until the end of the 180 day timeline to schedule closing on the replacement property for this exact issue.
We are here to help:
Avenue Legal Group helps clients navigate any and all stages of a 1031 exchange located in Oklahoma, or for Oklahoma-based clients investing in other states. Contact Avenue Legal Group to ask questions or discuss how we can help with your 1031 exchange.
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