If you’re considering selling a rental or other investment property in the East Valley but worried about a big tax bill, a 1031 exchange might be worth exploring to help you defer taxes when you swap into another property. The rules around 1031 exchanges are strict and the timelines are short, so planning definitely matters. In this guide, we will share some basic information that you should be aware of before using a 1031 exchange here in Arizona. Let’s dive in!
1031 Basics in Arizona
Named for the section number of the tax code, the 1031 exchange is a federal tax rule that allows property owners to defer capital gains when selling one qualifying property and purchasing another qualifying property. Of course, such a powerful rule has tight boundaries, one of which is that both the sold property and the new property that is being purchased to replace it must be held for investment or used in a trade or business.
In Arizona, small landlords and local investors often use 1031 exchanges to handle changes within a rental property portfolio, such as selling an existing rental house to upgrade to a multifamily building.
Like-kind property rules
For real estate, the definition of like-kind real property tends to be quite broad. Most often, you’ll find that almost any investment or business real property can be exchanged for almost any other investment or business real property, regardless of its specific type or quality. For example, in many situations, the proceeds of the sale of an East Valley rental house could be used to buy a small Gilbert apartment building, an industrial building, or potentially even a piece of qualifying land.
However, it is important to note that primary residences usually do not qualify for a 1031 exchange. If a property has mixed use, or you plan to convert a replacement property to personal use, you need to leverage the services of a qualified tax professional well in advance of attempting to execute your plan. After all, just about the only certain things are death and taxes.
Key Timelines in a 1031 Exchange
For the most part, the following key timelines control your 1031 exchange. Understanding these timelines and keeping them top-of-mind is of the utmost importance for a successful exchange:
-
Identification Deadline - Once the property that you are exiting (the one whose proceeds you’ll move into the new purchase) has been sold successfully, you have 45 days to identify possible replacement properties in writing and deliver that list to your qualified intermediary. Be sure to seek professional tax guidance regarding how to correctly assemble and deliver a qualifying list of replacement properties.
-
Exchange Deadline - From that same closing sale date, there is a total of 180 days available to close on your replacement property.
Qualified Intermediary
Because the person or entity executing the 1031 exchange cannot receive or control the sale proceeds, a qualified intermediary must hold the funds and document the exchange to ensure that everything is completed appropriately. Essentially, this qualified intermediary is an independent third party who prepares exchange agreements, receives your identification notices, and coordinates with title/escrow and accountant as necessary.
Boot in 1031 Exchanges
Because 1031 exchanges apply only to real property and it is rare for the values of two pieces of real property to match perfectly, it is also important to understand the concept of Boot. Put simply, Boot is anything you receive that is not like-kind real estate, such as cash, non-like property, or potentially a net reduction in mortgage debt. It is key to understand this concept and to work with your tax professional to prepare for these items in advance, since Boot can be taxed to the extent of your gain.
Sample Timeline for a 1031 Exchange in Arizona
Before Listing
-
Speak with your CPA about tax goals, planning, and the details of your exchange plan.
-
Select a qualified intermediary for your exchange.
-
Confirm your ownership structure and how you will take title on the replacement.
When Selling
-
Add any necessary 1031 exchange language to your listing agreement and purchase contracts.
-
Locate potential replacement property options.
After Selling
-
Once you close the sale of your current property, the funds should go to your qualified intermediary. This closing date begins both the 45 and 180 day clocks.
-
Deliver your final identification list to your qualified intermediary prior to Day 45.
-
Close on the replacement property or properties prior to Day 180.
Avoid These Costly Mistakes
1031 exchanges are not the simplest process, so it is important to proactively plan to avoid many of the errors that are most likely to occur in the process, including:
-
Taking possession of the sale proceeds instead of having them delivered directly to the qualified intermediary.
-
Missing the 45 day identification period, or creating a property list that does not meet the corresponding requirements.
-
Reducing your net debt in the sale, resulting in the accidental creation of taxable boot.
-
Changing ownership entities between sale and purchase.
-
Attempting to exchange a flip or a personal residence.
How the Lowery Premier Team Can Help
It seems rather obvious that 1031 exchanges come with a significant increase in complexity compared to the purchase or sale of a single property. The sequential sale and purchase, the limiting timelines, and the addition of the qualified intermediary all add complexity and communication to the process. From managing communication with buyers, sellers, title/escrow, and the QI, to selling your existing property successfully and helping you to purchase a strong replacement property, the Lowery Premier Team is primed to make the most of your exchange.
If quick communication, clear numbers, and confident execution under tight timelines are important to you, we would love to help you plan and execute your East Valley exchange. Together, we will map your sale, shortlist replacement property options, and set a timeline that works. Connect with our team today to begin creating a roadmap for the success of your exchange!
FAQs
What counts as like-kind real estate in a 1031 exchange?
-
For real property, most types of investment or business real estate may be exchanged for other investment or business real estate.
What are the 45 day and 180 day rules in a 1031 exchange?
-
Beginning from the closing of the sale of your existing property, exchangers must identify replacement properties correctly in writing within 45 days and close on the replacement property within 180 days..
What is boot in a 1031 exchange?
-
Boot is value from an exchange transaction that is non-like-kind, such as cash or net debt reduction.
Can I exchange a rental house for my next personal residence?
-
A replacement property intended for personal use is unlikely to fit within the 1031 exchange rules can disqualify your exchange. Mixed-use or conversions require careful advance planning with a CPA.
Professional Tax Advice
Please note that, while we are excellent at what we do, our team is not licensed as CPAs or professional accountants. We strongly suggest that you consult a tax professional prior to attempting any real estate investment and/or 1031 exchange activity.
