How does a 1031 exchange work?
When going through a 1031 exchange, the first step that needs to happen is the process of finding a qualified intermediary, also known as a “Q.I.” The qualified intermediary is the middleman throughout the entire 1031 exchange process. It's critical to find an experienced Q.I. who understands how to manage the process from start to finish.
Once you find the qualified intermediary, you should inform them that you're in escrow with the property. There are two key timeframes which you have to keep track of:
1. Identification Period: From the date you sell your property, you have a 45-day time period to identify (in writing) the new property or properties that you're interested in purchasing in the exchange. Within this 45-day time period, you can choose up to 3 options:
–Three-Property Rule: Identify up to three properties at any price. This is the most common option.
–200% Rule: Identify an unlimited number of properties; however, they can total no more than 200% of what you sold your property for.
–95% Closing Rule: Identify an unlimited number of properties so long as you close on 95% of them.
2. Exchange Period: After the identification period, the seller will have 180 days to close on the new property they've identified.
Both of these time periods occur in tandem once you decide to sell your property through a Q.I.
Real estate investors should know that these dates are non-negotiable. If you cannot find a property to exchange within either window, the deal is no longer valid and taxes will be due come tax season.
If you identify a “like-kind” property or, in other words, you've listed identified properties to your qualified intermediary, then the process will start to look like a traditional sale. The main difference is the proceeds from your sale will have to be held in escrow with your Q.I, and there will be extra paperwork at closing.
Instead of selling directly to the seller, the property will be sold to the Q.I. The Q.I. will hold the title and sell the property to the new buyer immediately. At the same time, the buyer transmits the funds to the Q.I. to hold.