What is a Delayed 1031 Exchange and How Does it Work?

For real estate investors, 1031 exchanges make it easier to delay paying capital gains taxes when they sell existing properties and purchase new ones. But there are several types of exchanges that investors can use to defer capital gains taxes. For example, delayed 1031 exchanges can offer more flexibility and give investors more time to find a suitable replacement property.

Let's take a closer look at how these exchanges work.

What is a Delayed 1031 Exchange?

A delayed 1031 exchange is a type of real estate investment strategy that allows an investor to sell one property without immediately having a replacement property lined up. Once the original property, also known as the relinquished property, sells, the investor can use the proceeds to purchase a new replacement property. The replacement property must be of equal or greater value and must be like-kind, meaning it’s a real estate interest of a similar nature to the relinquished property.

What Are the Requirements for a Delayed Exchange?

Delayed 1031 exchanges are governed by IRS Section 1031 exchange rules. These rules allow investors to defer capital gains taxes when they complete a 1031 exchange. However, to be eligible to complete a delayed exchange, you must be able to meet the following requirements:

Use a Qualified Intermediary (QI): Qualified Intermediaries oversee the exchange and ensure that all requirements are fulfilled. You must work with one on each exchange you complete.
Follow the time limits: You must identify an appropriate replacement property within 45 days of selling your relinquished property and complete the delayed exchange within 180 days of the sale.
Adhere to property requirements: The replacement property must be a like-kind property used for investment purposes and must have a value equal to or greater than the property you’re selling.
No access to funds: You cannot access the proceeds from the sale of your relinquished property during the exchange.
Document the exchange: The exchange must include the appropriate documentation. You’ll want to have a written agreement between yourself and the Qualified Intermediary, documenting all components of the exchange.

These requirements exist to ensure that you’re in compliance with the IRS’s regulations. Failure to comply with any of these requirements could result in you paying capital gains taxes on the sale of your relinquished property.

How to Complete a Delayed Exchange

Completing a delayed exchange can help you save thousands of dollars in capital gains taxes while still helping you grow your real estate investment business. But to complete one according to the requirements set by the IRS, you’ll want to follow these five steps.

1. Sell the Relinquished Property

In a delayed like-kind property exchange, you’ll need to sell the relinquished property before finding a replacement property. There are several ways you can go about doing this. You can find a buyer on your own, work with a real estate agent, or leverage your network to see if any other investors may be interested in purchasing it.

2. Find a Qualified Intermediary

Once you find a buyer, you’ll need to secure a qualified intermediary to oversee the exchange. You’ll want to choose a QI who has experience helping investors with delayed exchanges and one who has a good reputation in the industry. This way, you’ll have access to expert advice through every step of the process.

3. Identify Potential Replacement Properties

Successful exchanges rely on investors identifying suitable replacement properties. There are three rules you can use to help you choose the right like-kind properties:

The three-property rule: This rule states that real estate investors can identify and purchase one, two, or three replacement properties under a delayed exchange.
The 200% rule: Under this rule, you’re able to choose more than three replacement properties. However, the combined value of those properties must not exceed 200% of the value of the relinquished property.
The 95% rule: This rule states that real estate investors can identify more than three properties with a total value greater than 200% of the relinquished property. However, investors must acquire at least 95% of that total value for the exchange to work. This can be difficult, especially in competitive markets.

Remember, the properties you identify must be like-kind properties to qualify for an exchange. They must also have a use that is qualified for exchange, meaning they must be investment properties and can’t be used as a primary residence or personal vacation home.

4. Purchase the Replacement Property

Purchasing a replacement property is similar to purchasing any other type of real estate. You’ll need to negotiate the price and terms with the seller for each property you’re purchasing. Then, you’ll sign a purchase agreement for the property and assign the real estate contract to the QI who will facilitate the exchange. The QI will use the funds from the sale of your relinquished property to purchase the replacement property. The QI will direct the seller to transfer title to the replacement property directly to you.

5. Report the Exchange

After completing the exchange, you need to notify the IRS. You'll do this when you file your tax return for the year you completed your exchange. The IRS requires you to fill out Form 8824. The form indicates to the IRS that you’re taking advantage of your capital gains deferral from the sale of the property and will keep you from having to pay capital gains taxes for that year.

Pros and Cons of a Delayed 1031 Exchange

Delayed 1031 exchanges can be useful tools for real estate investors who want to defer their capital gains tax liability. But before you make the decision to pursue a delayed exchange, you’ll want to familiarize yourself with the pros and cons.

Pros

Here are some of the benefits you can expect to see when using a delayed 1031 exchange:

Easier funding: When you perform a delayed exchange, you can use the proceeds of your sale to pay for the replacement property. This could save you cash upfront.
Facilitates diversification: With a delayed exchange, you’re able to purchase a different type of property than the one you’re selling as long as it’s an investment property. This may help you diversify your portfolio and hedge against falling performance in other property types.
Better flexibility in hot markets: Delayed exchanges let you focus on selling your relinquished property first. This can be ideal in competitive or hot markets as you’ll have more time to find the right buyer willing to offer you top dollar before you start searching for a replacement property.

Cons

Here are a few of the downsides you may see when using a delayed 1031 exchange:

Requires strict time constraints: You must adhere to the 45-day and 180-day timelines to complete the exchange. Failure to do so could mean you have to pay capital gains tax on the sale. This is often referred to as ‘boot liability.’
Defers taxes rather than eliminating them: Delayed exchanges only defer your capital gains tax liability. It won’t eliminate it entirely. If you sell the property without exchanging into another replacement property, you’ll owe the taxes you originally deferred once it sells.
Exposes you to some risk: Since you have to follow a strict timeline, there’s a risk that you’ll overpay for a property in order to close the deal before the timeline elapses.

A Delayed Exchange Could Be the Right Strategy for You

Delayed 1031 exchanges can be a great tool for real estate investors looking to defer capital gains taxes while still expanding their portfolios. You’re able to sell an existing property and use the proceeds from that sale to purchase a replacement at an equal or greater value, all while deferring your tax liability.

But the key to completing a delayed exchange lies in getting reliable and trustworthy advice. First American Exchange Company is here to help. Contact us today to get help with your delayed exchange.