Today, we’re going to walk you through a standard 1031 exchange step-by-step at Midland. Although this is a fictional example, Midland has been completing similar transactions for the past 25 years. Our exchange specialists have over 50 years of combined experience and want to help you get started.
Meet Sarah: a savvy real estate investor who owns a residential rental property called "Sunset Apartments." She owns the property in a single-member LLC named Sunset Apartments, LLC. It's a 10-unit apartment complex located in a popular beach town. Sarah has been receiving rental income for several years, while the property has significantly appreciated in value.
After some debate, Sarah decides she wants to diversify her real estate portfolio and explore new investment opportunities. However, she's concerned about the potential capital gains taxes she would have to pay by selling Sunset Apartments. She consults with her tax advisors, who introduces her to a 1031 exchange. This would allow her to purchase properties of the same or higher value and defer paying the capital gains tax.
After careful consideration, Sarah decides a 1031 exchange offers her the best opportunity for her investment. With a 1031 exchange, she will not pay any taxes. This assumes she purchases an investment property of the same or greater value than the NSP of the relinquished property.
NSP or Net selling price can be defined as gross sales price minus the closing costs. Note that a mortgage loan is not considered a closing cost. She determines that a commercial office building in a thriving business district is a suitable replacement property for the exchange. It offers the potential for higher rental income and sits in an area with strong demand.
Her tax advisor informs her that she will need a qualified intermediary or a QI. A QI is a third-party facilitator to handle the exchange process. After research, Sarah contacts Midland 1031 to complete the exchange. She provides the intermediary with the necessary information including:
- the details of the properties involved
- their values, and
- the intent to complete a 1031 exchange.
Midland prepares the exchange agreement before the sale of the relinquished property. With the help of her QI, Sarah sells Sunset Apartments for $2 million. She is now in the 180-day exchange period which starts at the closing of her relinquished property. Sarah will not receive the proceeds directly. The QI holds the funds in a segregated escrow account.
Sarah has 45 days from the sale to identify potential replacement properties. During the identification period, Sarah finds the perfect replacement property—an office building priced at $3 million. She then notifies the QI directly of her choice within the specified timeframe.
At the closing of the replacement property, Midland transfers the $2 million to the title agent. This ensures that Sarah doesn't personally receive the funds to defer the capital gains. As QI, Midland 1031 will be on the closing statement and will sign the HUD-1 Statement.
Sarah has now successfully completed a 1031 exchange, acquiring the office building. The exchange allows her to reinvest the full proceeds of the sale into this new property. If she hadn’t, Sarah would have paid taxes on any funds not utilized in the exchange. Sarah will report her exchange on her tax return using Form 8824.
It's important to note that this example is for illustrative purposes only and doesn't constitute legal or financial advice. 1031 exchanges involve specific rules, requirements, and tax implications that should be thoroughly understood and considered with the assistance of professionals. Please feel free to contact Midland 1031 for your next exchange at 239-333-1031.