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Have you heard of a 1031 exchange and how it can help you reduce your tax burden?
A 1031 exchange involves swapping two similar investment properties to increase wealth while avoiding taxes on the sale or purchase.
With a successful 1031 exchange, you can defer your capital gains taxes until the next sale of your 1031 exchange real estate.
Many property owners and real estate investors utilize multiple 1031 exchanges to put off paying capital gains taxes for years.
It is a form of estate planning, as the government voids taxes posthumously, so this can lead to good financial growth if you plan for the long term.
Before deciding if a 1031 exchange is the right investment move for you, take some time to learn about the rules and regulations.
This type of exchange does not work with any property, but the stipulation of “like-kind” properties has a surprisingly lax definition.
If you need to know about the 1031 exchange tax deferral, this is the guide for you.
What is a 1031 Exchange?
A 1031 exchange is a real estate investment term for a tax deferral. Specifically, the 1031 exchange allows someone who purchases a similar property of equal or better value to not pay capital gains taxes on the property sale.
It may seem like a loophole, but it is completely legal. However, they are not completely free of taxes; they will have to pay taxes on the property upon selling.
How Does a 1031 Exchange Work?
A 1031 exchange gets its name from the 1031 tax code. Internal Revenue Code (IRC) Section 1031 states that any exchange of properties of similar use can be exempt from most taxes.
While the owners must invest in the properties, very few other rules exist. The IRS considers a property swap an investment and an excellent way to improve the economy.
Therefore, the 1031 swap is a good way to encourage investors to continue growing without becoming a monopolizing force.
Essentially, a real estate investor can purchase a more expensive piece of real estate and not have to pay extra taxes on it.
They then store up the gain that they receive until they sell that real estate. Unless they sell it in another 1031 exchange, they then pay taxes on that property.
This allows them to invest in high-cost properties without necessarily having the funds needed to pay taxes on them.
Example of a 1031 Exchange
A 1031 exchange might be easier to understand with an example. Imagine that a real estate investor owns a set of condos worth $2 million.
Their real estate agent informs them that a higher-value property is on the market for $3 million.
If they want the higher-value property, the investor and real estate broker can work within a 1031 exchange to sell the $2 million property and purchase the $3 million property, putting the money from the sale of the first property toward the purchase of the second.
Essentially, the real estate investor gains a better building and avoids paying thousands of dollars in taxes.
If they end up selling the new building, they will then have to pay taxes on it. However, until then, they can enjoy the same building taxes as on the lower-value building since they essentially swapped one building for the other.
1031 Exchange Rules & Requirements
Of course, there are very specific rules for a 1031 exchange. To work correctly, the exchange must follow a specific timeline, involve certain third parties and include specific types of buildings.
To complete a 1031 exchange, the parties must thoroughly document the transaction and register it with the IRS as part of their end-of-year tax returns.
As long as the transaction, the properties and the exchange meet all the requirements, the IRS will not tax the buildings.
Although there are different ways that the rules can potentially be interpreted, all official 1031 exchanges need to follow the rules.
Here are the in-depth requirements you need to know to successfully perform a 1031 exchange.
For a property to be eligible for a 1031 exchange, the exchange must meet three major requirements:
- The property must be an investment property of some kind.
- The purchased property must be worth more than the sold property.
- The two properties must be similar types of investments.
The first requirement is that the property is an investment property. This means a person cannot perform a 1031 exchange on their own house or primary residence.
It must be a property that the buyer will primarily use for income, or one that acts as an investment of some kind).
The purpose of a 1031 exchange is to give an investor a tax break on a more expensive investment. If the purchase is worth less, the investor depreciates and voids the 1031.
Because of this, the property the investor is selling must be worth less than the purchase.
Finally, the two properties must be “like-kind” investments. The law is surprisingly loose surrounding this definition, so any variation of properties that fall under similar investments will work.
A real estate lawyer or experienced agent can help define these terms further.
The “like-kind” requirement is the loosest of the rules, but it can lead to more income taxes. For example, an investor could sell an apartment building and purchase a more expensive piece of land with no building.
In that case, the depreciation might be income tax.
Although the ideal 1031 exchange would happen simultaneously, it is extremely rare for real estate properties to sell at the same time.
Usually, the investor will sell their property before buying another. However, investors must stick to specific timelines.
1031 exchange timeline
A proper 1031 exchange has specific time limits. Of course, if you know someone who wants to switch properties with you, you do not necessarily need a strict timeline.
However, the odds of this are low, and most 1031 exchanges use a third party. A third party is necessary because the primary investor cannot hold any cash from the sale.
A trusted third party, usually a real estate agent, must hold the funds in escrow until the seller can invest them in a new property.
There are two main time frames to keep in mind for a 1031 exchange: 45 days and 180 days. It is important to note that both of these time frames start simultaneously, and you will have 180 days to finish your 1031 exchange after you sell a property.
Within 45 days of selling the first property, investors must designate which property they intend to purchase with cash.
Usually, you would do this by writing to your intermediary, who is holding the funds from the sale. You will let them know which building or property to purchase.
If you are not sure you will get the primary property you want, you can list up to two backups for your real estate agent as long as they have this in writing within 45 days.
Within 180 days of selling your property, you must purchase the 1031 exchange property. If you do not close on the second property within 180 days, the 1031 exchange is void.
However, if you purchase the second property in that time, the 1031 exchange process is complete. The 45-day rule and 180-day rule also apply to reverse exchanges.
If you purchase a new property before selling your old one, you must finish the selling process within 180 days to protect partnership interests.
Types of 1031 Exchanges
While all 1031 exchanges follow the same basic process, there are a few different 1031 exchanges. You can work within a delayed exchange, a reverse exchange, or a build-to-suit exchange.
A delayed exchange is a standard 1031 exchange, but the parties delay the exchange to account for the real estate market and property availability.
Most 1031 exchanges count as delayed exchanges, as the investor sells their property before purchasing the exchange.
During a standard delayed exchange, parties still have to observe the 45- and 180-day rules. A third party holds the cash from the property sale in escrow until the owner makes the sale.
If the investor receives any cash, it nullified the 1031 exchange, and they must pay taxes.
In some situations, investors purchase the new property before selling their own. This is called a reverse exchange and usually only happens in a seller’s market or if the buyer gets a great deal.
In the case of a reverse exchange, the timeline is still intact, but it reverses the deadlines. The investor must sell their old building or property within 180 days to complete the trade and has 45 days to tell their intermediary which property they intend to sell.
With build-to-suit exchanges, the purchaser can make improvements to the property. As long as they complete the upgrades within 180 days, the deferred tax dollars can go towards construction and improvement work.
These exchanges are rare, especially since they must complete the work on the building within 180 days from the sale of the other building.
It can be challenging to arrange construction workers and schedules, so many people choose a regular, delayed, or reverse exchange.
Tax Implications of a 1031 Exchange
While the 1031 exchange is easy enough to understand, its reasoning might seem complicated. It is all for a tax deferral, but what is the tax law?
How can you save money with this exchange? It can get complicated, but a good real estate agent and accountant can help.
Without a 1031 exchange, the government will consider any proceeds from a property sale as capital gains. In the case of a high-value investment property, investors could lose thousands of dollars in taxes when they sell.
However, a 1031 exchange puts off that taxing until they sell the new building. Hypothetically, an investor could continue to make 1031 exchanges on better and better buildings, avoiding taxes until they sell the final building.
However, that building would have very high sales taxes. There are other tax implications in a 1031 exchange. If you make extra money from the sale, you have what financiers call a boot.
It is taxable as capital gain, as it is part of the sales proceeds. Any extra money or property you receive within the exchange transaction counts.
The other area that can confuse investors is the mortgage. If you sell a building with a mortgage on it, you may be eligible for taxes.
If your new building has a lower mortgage amount, that difference is income, and you will have to pay taxes on it.
These small taxes are negligible compared to the money investors save by participating in 1031 exchanges.
They can grow investments while saving tax money if they make the property exchange correctly, allowing them to put more funds into their pockets.
Benefits of 1031 Exchanges
There are several benefits of 1031 exchanges. Of course, the main advantage is that the IRS does not tax property sales and capital gain from those sales.
Instead, investors can improve their holdings without paying more taxes through tax-deferred exchanges.
The more investors successfully swap properties in a 1031 exchange, the better off they are. The amount of deferred taxes will grow, and investors will save more and more money.
Many investors use 1031 exchanges for their estate, as the government forgives taxes posthumously.
The main purpose of 1031 exchanges is for investment. Because of this, it is an excellent way for real estate investors to continue finding new properties and avoid paying sales taxes on the properties they sell.
It allows them to upgrade their properties and portfolios. Of course, the government also receives benefits from this exchange.
By providing a tax break for a property swap, the IRS prevents taxpayers from buying too much property and becoming a monopoly.
It is one of several checks in place, but investors like the benefits.
Disadvantages of 1031 Exchange
Of course, no investment strategy is perfect. There are multiple benefits to a 1031 exchange, and it works for many people, but it is not ideal for everyone.
One disadvantage is that a 1031 exchange can be complicated to complete, but it is possible with a good advisor.
The most significant disadvantage of a 1031 exchange is the eventual payout of taxes. Unless you decide to use your 1031 exchange real estate, you will eventually have to pay taxes on your final sale.
This can pile up, depending on how many 1031 exchanges you perform. Another disadvantage is the time constraint.
Having everything in line and set up before you start is crucial. One hundred eighty days is not a lot of time, especially if you need to sell a property.
While the time constraint is necessary for like-kind exchanges, it can be stressful. 1031 exchanges are solely for investment properties; you cannot complete them on residential or personal property.
The tax break is only for certain buildings and properties that meet certain standards, so you will not be able to sell your own home with a 1031 exchange.
You also cannot keep two similar properties. While a 1031 exchange allows you to sell and upgrade without paying extra taxes, you will still need to sell your old property and pay more for your new one, as a 1031 exchange requires that the new property is of equal or greater value.
A 1031 exchange is a property swap that defers the regular taxing on capital gains and sales tax. In a 1031 exchange, a real estate investor will sell a like-kind property and exchange it for a property of equal or greater value, giving themselves a better, tax-free investment.
If you are interested in a 1031 exchange, talk to your real estate agent about starting the process.
Good luck, and happy investing!
1031 Exchange FAQ’s
Here are a few questions many people have regarding 1031 exchanges and other tax-deferred real estate properties.
What is a qualified intermediary?
In any 1031 exchange, it is crucial to have a qualified intermediary who will act as an exchange facilitator, handling the cash and doing the actual purchasing and selling.
Because they have such an important role, the intermediary must have official real estate qualifications.
Can you do a 1031 exchange on a principal residence?
A 1031 exchange is solely for investment properties, so it will not work on a principal residence.
The only way to do a 1031 exchange on a home is to use it as an investment property for a reasonable amount of time before trying to exchange it.
Can you do a 1031 exchange on a second home?
A second home for personal use does not qualify for the same reasons as a principal residence.
However, if you turn your vacation home into a rental property for several years, it then becomes an investment property.
How do I change ownership of a replacement property after a 1031 exchange?
If you intend to change your 1031 exchange property ownership, you will have to wait several years.
Because the purpose of a 1031 exchange is to invest, changing owners can be difficult, and you might have to pay the taxes that you avoided during the exchange.
What is a 1031 exchange depreciation recapture?
1031 exchange depreciation recapture occurs when you purchase a property with a different level of depreciation than your original property.
Typically, this happens when an investor exchanges a building for vacant land with no facilities on it.