What Is a 1031 Exchange?
The 1031 Exchange allows a person to sell one or more appreciated assets (generally rental or investment real estate, but could be non-real-estate) and defer the payment of your capital gain taxes by acquiring one or more replacement properties. 1031 Tax Deferred Exchanges allow you to keep 100% of your money (equity) working for you instead of paying (losing) about one-third (1/3) of your funds (equity) to taxes.
There are, of course, very specific requirements that you must follow so that your sale transaction will qualify for 1031 Tax Deferred Exchange treatment under Section 1031 of the tax code. We can help you sort through it all!
Some terms you will need to understand before reading ahead:
- Relinquished Property: the property you want to sell
- Replacement Property: the property you decide to buy
- Identification Period: the deadline of 45 days subsequent to the sale of your relinquished property to identify the replacement property
- Exchange Period: the deadline of 180 days from when you close on the relinquished property to close on the replacement property
- Qualified Intermediary: (also called accommodator) the uninvolved third party who holds the investor’s sales proceeds from the sale of their relinquished property in a third party account until you close on the replacement property
What are the benefits of a 1031 Exchange?
Many people get into real estate investing because of its tax advantages. As a rental property owner, you can deduct some of the expenses associated with your property to lower your overall tax liability, all the while making passive income. Selling an investment property, on the other hand, can be a daunting task, especially if you have earned profits from it and received depreciation credits. In this case, a 1031 exchange is an invaluable opportunity to avoid capital gains and other taxes on the sale.
Real estate investors use 1031 exchanges to reap the main benefit of deferring capital gains tax. These savings can be huge, and help investors build more capital to invest further. Beyond the tax advantages though, there are many other benefits of a 1031 Exchange that make real estate investing so rewarding and enjoyable.
Additional Benefits of a 1031 Exchange
- Greater Income Capacity - A 1031 Exchange lets you upgrade to a property with higher returns or qualities that better match your investing goals. You can sell raw land and trade up for an income-producing property like a multi-family residence, or sell a single-family home for an apartment building. Your profit margin is scalable!
- Relocation to New Markets - Want to invest in an up-and-coming market with budding potential? Like-kind exchanges aren’t limited to your relinquished property’s state lines. Diversify your portfolio by moving into another market!
- Consolidate Your Assets - Owners of multiple properties can exchange them for one property that is easier to manage and potentially more profitable.
- Reset Your Depreciation - you can write off depreciation of your asset to compensate for deterioration related to the wear and tear, aging or other structural obsolescence of the home. In a 1031 Exchange, your CPA may elect to reset the depreciable amount of your investment property to a higher value that would give you a bigger tax benefit.
How does a 1031 Exchange work?
There are a few different options in using a 1031 Exchange to your advantage. For now we’ll talk about a Deferred Exchange, since this is the most commonly used.
The Deferred 1031 Exchange Process
- An investment property owner will first list their rental property for sale as usual, making it a relinquished property.
- When a capable buyer submits an offer and the purchase contract is executed, the seller enters into an exchange agreement with a qualified intermediary who, in turn, becomes the substitute seller.
- Once the sale closes on that deal, the sale proceeds are transferred into a qualified intermediary’s exchange account where they are held.
- You have 45 days from the sale of your relinquished property to identify a valid replacement property. A replacement property is considered valid if one of the following is true:
- You find up to 3 different properties as potential purchases within the 45-day identification period, not taking into account their fair market value.
- You find an unlimited amount of replacement properties as potential purchases, as long as the total fair market value of all properties does not exceed 200% of the value of the relinquished property.
- You find an unlimited amount of replacement properties as potential purchases, as long as you receive at least 95% of the value of all identified replacement properties.
- Perform due diligence, submit an offer, and close on a replacement property, all within the exchange period of 180 days after the close of your relinquished property.
- Receive sale proceeds from your qualified intermediary.
While this process seems simple enough, the 1031 laws are rigid and do not offer any leeways or grace periods. To avoid any risk, do your homework on finding a replacement property as soon as possible. Also, consult with a 1031 Exchange real estate expert that can help you navigate the 1031 Exchange process, free from error.
What qualifies for a 1031 Exchange?
According to IRS Code 1031, Section 1031(a)(1) provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment.”
An exchange is “like-kind” if your property is being used as an investment or for income-producing purposes, and you replace it with another investment or income-producing property. Real property is generally considered to be of “like-kind” regardless of whether the properties are improved or unimproved, and doesn’t necessarily mean a house for a house. For example, the exchanger could sell a commercial space and purchase land or sell a rental home and buy an apartment building.
The IRS has created a list of who qualifies for a 1031 Exchange:
- C corporations
- S corporations
- Partnerships (general or limited)
- Limited liability companies
If you are a tax-paying entity, you qualify for a 1031 Exchange.
What does not qualify as a 1031 exchange?
In order to be fully tax-deferred, you must sell and reinvest in real property with income-producing purposes. In other words, you can’t swap one primary residence for another. The following will disqualify you from being eligible for a 1031 Exchange:
- Personal property usually does not qualify for an exchange because it is not used in trade, business or investment. This would include a primary residence and a second home.
- You cannot buy property that you intend to “flip” quickly for profit.
- While you can sell a property to a related party, you cannot purchase the replacement property from a related party.
- You cannot buy or sell property outside of the United States.
Are there different ways to perform a 1031 Exchange?
There are 4 common options in performing a 1031 Exchange. The most common like-kind exchange types include the simultaneous, delayed, reverse, and construction or improvement exchange. Depending on what order you acquire a replacement property and sell your relinquished property, you will fall under one of the options below:
- Delayed Exchange: the property owner relinquishes the original property before he acquires replacement property. This is the most common type of exchange investors utilize.
- Simultaneous Exchange: occurs when the replacement property and relinquished property close on the same day. Any delay can result in the disqualification of the exchange and the immediate application of full taxes. This is the oldest type of exchange, and can happen one of 3 ways.
- Swap, or Two Party, Trade: Two parties exchange (swap) deeds with each other. This option does not require the use of a qualified intermediary, but can be difficult to complete. Both properties must have the same amount of equity and debt, and the other party has to want to acquire your property at exactly the same time you want to acquire their property.
- Three Party Exchange: An “accommodating party” is used to help facilitate the transaction for the taxpayer. In the Alderson format, title is passed through the buyer. In the Baird format, title is passed through the seller. There is no need for a qualified intermediary.
- A Simultaneous Exchange: a qualified intermediary is used to structure the exchange. The QI provides written instructions to the closing officers, prepares the exchange agreement and other necessary exchange documents which insulates the taxpayer from any “constructive receipt” issues.
- Reverse Exchange: (also known as a forward exchange) occurs when you acquire a replacement property through an exchange accommodation titleholder before you exchange the property you currently own. In theory, this type of exchange is very simple: you buy first and you exchange later. What isn’t so simple is that reverse exchanges require all cash, as most banks will not offer loans.
- Construction Exchange: allows investors to make improvements on the replacement property by using their tax-deferred dollars to enhance the property while it is placed in the hands of a qualified intermediary.
How long does it take to do a 1031 exchange?
In order to complete a 1031 Exchange effectively, your sale and purchase must fall within a strict timeline. Make sure you have a clear picture of the type of exchange you plan to execute, since each exchange has its own time requirements. To protect yourself from incurring tax liability, be mindful of the following deadlines:
Delayed Exchange Deadlines
- You have 45 days from the sale of your relinquished property to identify a valid replacement property.
- You have 180 days after the close of your relinquished property to close on your replacement property.
Simultaneous Exchange Deadlines
- The exchange on your relinquished and replacement property must happen at the same time.
Reverse Exchange Deadlines
- You have 45 days from the sale of your relinquished property to identify a valid replacement property.
- You have 135 days after the close of your relinquished property to close on your replacement property.
Construction Exchange Deadlines
- The entire exchange equity must be spent on completed improvements or as a down payment within 180 days.
- You must receive “substantially the same property” that was identified within 45 days.
As you can see, each type of 1031 Exchange requires its own set of time restrictions.
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