I get it: Tax documents are probably the last thing you want to think about as you head into the new year but trust me: you don’t want to learn about this one the hard way. Even if you’re just thinking about buying or selling an investment property this year, knowing about the 1031 Exchange can save—or cost—thousands of dollars.

Kacey Neer, Lead 1031 Exchange Coordinator from Land Title Exchange Cooperation gives some insight into this important (and often misunderstood) federal program.

What is a 1031 Exchange?

It’s a program designed by the IRS to help real estate investors defer capital gain taxes. If a real estate investor is selling an investment or business property and wants to use the proceeds from that sale to invest in a new property, they would engage in a 1031 Exchange to defer capital gains taxes.

Who is qualified?

There are specific individuals that can do it because it is not an ordinary program. Attorneys can do it, and certain title companies have Qualified Intermediaries, but it can’t be someone who is already related to the transaction.

What’s the process?

First, it’s crucial to talk to a CPA to make sure it will work with your tax structure and financial goals. Once you’re under contract to sell your property, you would then engage a 1031 Engaged Qualified Intermediary to get the process started.

Why is this important to know and understand?

A 1031 Exchange is a very specific program with firm regulations. While it is a great resource, it may not be the best option for everyone. There are many tax implications to think about when selling an investment property, so we highly suggest clients speak to their CPA or tax attorney prior to engaging in a 1031 Exchange.

What are some things people often misunderstand about the 1031 Exchange?

Often people think they can set up a 1031 Exchange after they have closed on their property and are in receipt of the proceeds. If at any time the client has receipt of the funds, they are disqualified from participating in the program. The Exchange must be set up prior to the sale so that the Title Company sends the funds directly to the Qualified Intermediary.

What if you are buying a property out of state?

The client can buy in any state as long as the property they are buying is considered “real property.” There are a few states that we cannot start an Exchange in due to their laws, including Washington, Maine, Michigan, Idaho, and Nevada.

How long are the funds tied up for?

You have 45 calendar days from the day after the closing to identify the new property and 180 days to close on the new property. These deadlines run concurrently, and there are no extensions. The QI must hold the Exchange funds for at least the 45 day identification period, even if the client decides not to complete the exchange, unless the closing on the new property happens before that. If there are any Exchange funds left over after the replacement property has been purchased, they can be released as long as the client is past their ID period. If a client has identified a replacement property and is past their 45 day ID period but unable to close on the new property, the QI has to hold the funds the full term of the Exchange.

If a 1031 exchange isn’t in place, how much can people expect to pay for capital gains tax?

It’s really going to depend on their tax tier, but it ranges from 20-30 percent. It can be a huge bill. Also, if they don’t engage in a 1031 Exchange, they can get hit with depreciation recapture. That means the IRS can come back and charge them for a portion of any depreciation they’ve taken over the years, and that’s on top of capital gains.

How do you define an investment property?

It can’t be a primary residence or second/vacation home. It needs to be used for business or investment purposes.

What if you’re doing short term or vacation rentals, but also using the property yourself?

You can do VRBO or Airbnb, but they limit the amount of time you get to use it to 14 days per year. The rest of the time, you need to be renting it, or at least advertising it.

What advice would you have for an investor so they’re best prepared?

Timing is everything. Ideally, the client wants to start talking to their CPA and QI a year prior to selling the property. There are many things to take into consideration, such as title, that should be looked at before listing the property for sale.

Is the 1031 standard knowledge for most CPAs?

Most CPAs are aware of the 1031 Exchange program, but they may not necessarily be well-versed on them or up to date on the current regulations. It’s important for a client to work with a CPA that has a strong understanding of 1031s.