My wife and I navigated a 1031 for my In-Laws this year, and it worked out pretty well, given the potential pitfalls that come with it. It is really really really important that you work with a QI (qualified intermediary) that you trust, and who can help lay the groundwork with you, and can work with the title companies / closing agents that you as seller, and then you as buyer, are using. There are very strict time limits that you need to follow.
I'll use our scenario as an example, and what we thought about:
My in-laws own rental properties, of which they owned their first one with a relative for about 40 years. The relative wanted to liquidate but my in-laws liked the cash flow, and it was putting a strain on the relationship, so when an offer to purchase came out of the blue, it was time to move. The property was 100% depreciated, and would result in significant (to them) tax liability. Plus, my in-laws wanted to maintain cash flow, so we decided to go the 1031 route. Run these numbers yourself to see if it makes sense for you.
What's the going rate?:
From my research, the cost is around $1000, which includes the first closing, and then if you buy multiple replacement properties, each additional closing is about $500. We replaced one property with 2 smaller ones, so our total was $1500 for the 1031 service.
Why is Trust in Your QI so important?:
In order for a 1031 to work, you CANNOT touch the money, full stop. Remember that we are creating a fiction of a like-kind-exchange, where we are trading one piece of property for another. Since these properties are going to be owned by at least 3 people, we need to facilitate this trade with cash, in addition to shifting dates of ownership. So the IRS says you need to have a QI accept the cash and hold it for you from the sale of Property #1, and then wire the money to the seller of Property #2. This means all the closing documents and check that the seller presents at closing have your QI's name on it, not yours. This can be a little uncomfortable to watch a large sum of money pass in front of your nose, and you have very little recourse if things go sideways. Now, you may be thinking to yourself, "hmmm, I wonder what fiduciary duty this QI has to me, or what assurances I have that he won't blow it all on boats and sports cars?" The answer: NONE. See:
https://1031netex.wordpress.com/2008/03/20/man-behind-1031-exchange-scam-indicted-for-fraud/You would have to file suit claiming breach of contract, and hope there was an entity that you could collect from to make you whole.
Now, of course, our QI was a nationally known big time title company, and they were super cool, and we had a wonderful experience with them. But remember, it doesn't cost a whole lot to buy some swank Google AdWords and get yourself some clicks to your website. Plus, I will mention that Title Companies, even really reputable ones, have some pretty atrocious websites, so it may be hard to separate the wheat from the chaff on looks alone.
What if I accidentially "touch the money?":
If you, your attorney, or your agent gets paid part or all of the funds, either on purpose or by accident, then you could disqualify the transaction. So, let's say you sell a fully depreciated property for 1 Million, and replace it with another property for 1 Million, but you do something that accidentally disqualifies the transaction. Then, you would owe long term capital gain on the 1 Million, but potentially not have the cash to pay the tax, because it is all tied up in a Million dollar building. Granted, if you have your team in place, this shouldn't be a problem, but I mention this to STRESS that it probably isn't a situation where you might try to save a couple bucks by making your grade school best friend be your QI, and filling out the paperwork yourself.
So, what's The Time Line?: (See the IRS official explanation here, and where there might be discrepencies, TAKE THEIR WORD FOR IT:
https://www.irs.gov/uac/like-kind-exchanges-under-irc-code-section-1031)
Day 1: sale of "relinquished property" and check paid to the order of QI.
Day 45: Identification deadline of "replacement properties." This is basically a worksheet that you send to the QI with a list of properties from which you'd like to purchase. You may have "maybe's" on this list, and you may have more value than the relinquished property, but there are number limits on both.
Day 180: Must have finished closing by this date. There is a little wiggle room in the properties described, as the IRS states: "The replacement property received must be substantially the same as property identified within the 45-day limit described above."
What happens if I can't find anything I want to buy?:
If you don't find something you like to replace your relinquished property, then no harm, no foul. The QI will cut you a check (less their $1000 fee), and you'll pay taxes on the gain like normal. There is no additional tax burden for failing to complete a 1031. Note that the QI might want to hold onto the check for the full 180 days, depending on if you filled out a Day 45 Identification notice.
What else helps?:
Having a GOOD real estate agent that understands the time constraints of a 1031 is very very helpful. Also, your relationship with your title company, as well as their relationship with the QI is vital. We were lucky that they had worked together in the past, and it was incredibly seamless once the offers were accepted. What's nice about all cash deals is that you don't have a bank in the middle slowing things down.
In our situation, we had identified a couple of rental properties to purchase prior to closing on the sale of the Relinquished Property. As soon as closing occurred, we were conducting walk throughs, doing our due diligence on the leases, and putting together offer sheets on the replacement property. Unfortunately, the sellers didn't want to play ball, and after about a week of back and forth, we cut bait and started looking for other properties (as of today, still for sale. Tough stuff.). We actually found better options less than 2 weeks later, and had accepted offers prior to the 45 day deadline. The final closing occurred in July, and we have had 100% occupancy since August 1, and increased the Net Cash Flow by 40% over the Relinquished Property.
What if I want to buy a property that is worth more than my old one? Or, what if I want to spend less than I make on the old one?:
No problem! If you sell one building for 1 Million, and buy another for 1.2 Million, you can either pay out of pocket for the difference, or you can finance it.
Conversely, if you sell one property for 1 million, and buy another for $750,000, then the QI will cut you a check on day 181 (they usually hold it for the full 6 months) for the difference, and you pay tax on that difference.
These are my off the cuff observations. Was it easy? Kinda. Was it stressful? Sometimes. Would I do it again? Sure! Let me know if something wasn't clear, and I'll try to explain.
Rob