The 1031 tax code offers several attractive tax benefits for investing in real estate. However, one of these benefits — the IRS section 1031 exchange — is frequently misunderstood. Unknown to many, this tax code is an investment strategy that offers tremendous tax advantages. The idea driving the strategy is to defer paying capital gains tax on real property sales — provided the investors reinvest it within a certain period.
Similar to the 1033 tax code, the 1031 code provides investors the flexibility to trade like-kind properties, deferring capital gains taxes. It can save clients thousands of dollars in taxes while growing their portfolio balances if executed correctly.
If you are planning to sell your business and investment property, you may want to learn everything there is to know about one of the most effective tax strategies in real estate — the 1031 exchange. In this comprehensive guide, we’ll cover everything about 1031 exchanges and associated rules.
What is a 1031 Exchange?
Any capital gain you make on selling a business asset is taxable. However, the 1031 exchange provision allows you to postpone paying the tax on this gain if your reinvestment qualifies as a like-kind exchange.
Section 1031 of the United States Internal Revenue Code (IRC) permits taxpayers to defer recognizing capital gains and income taxes for a sold property. Also known as a “like-kind exchange,” this IRC policy provides a tax deferral in real estate investing by deferring capital gains taxes from the proceeds of one piece of property. You'll then use the proceeds to purchase a similar or qualifying replacement property.
For instance, let’s say you bought a property five years ago. After five years, the property’s value increased significantly, and you decided to sell it at a $500,000 profit. Let’s say your capital gain is 20% (this varies per state or local government laws). It means you owed the IRS a whopping $100,000 sales tax. However, due to the 1031 exchange, you can reinvest the profits from your sale into other property. This saves you from paying those taxes altogether.
It isn't taxable if you sold certain depreciable business assets that didn't earn gains. In addition, there are also tax implications and time frames associated with the exchange process. Not only that, but 100% of the proceeds must be held in escrow by a third party as a down payment on the new property. It will not be disbursed to you, even temporarily.
Candidates for 1031 Exchange
Generally, an investor must hold the relinquished property for investment purposes. However, not all properties are equal when considering a 1031 exchange. To partake, the property must be business or investment property like rental real estate, shopping centers, and office buildings. A personal property — like a residential home or a vacation house — usually doesn’t count. The same goes for stocks, bonds, insurance proceeds, or intangible assets.
Anyone can participate in a 1031 exchange, provided you can demonstrate that the property you sell generates passive income and has been used for business or investment purposes. Properties for personal use aren't eligible. Besides, the proceeds of this exchange may not be used to pay off personal debts — like mortgage payments on your primary residence.
1031 Exchange: Rules & Limitations
To make your transaction successful, you must be acutely aware of the rules and deadlines surrounding the 1031 tax code:
Properties must be like-kind: Property sold under the exchange code should be swapped for similar or like-kind properties. You can’t sell an investment property and then use your capital gains to buy a vacation house or intangible asset. According to the IRS, similar properties are “the same nature and character, even though they differ in grade or quality.”
Both properties don’t need to be precisely similar: For example, if you sell a piece of vacant land, you can trade it for an office building or a rental house. This is perfectly acceptable as long as such property is for business purposes.
You can buy a replacement property anywhere in the U.S.: If you are living in LA and plan to move to New York, you can sell your LA property and find a replacement property in NY. The IRS permits this scenario. It allows you to exchange like-kind properties anywhere in the United States.
An exchange allows purchasing multiple properties: As long as such property is used for business or investment purposes, it’s possible to buy multiple real estate from the sale proceeds.
The replacement property must be the same or greater value than your old property: To avoid paying capital gains taxes, the new property you buy must be equal to or worth at least as much as the relinquished property. If the value of the new property is less than your old one, you have to pay taxes on the difference, otherwise known as the "boot."
Both properties should have the same owner: The IRS requires that each property owner involved in the exchange be the same. Hence, you can’t sell an apartment complex under your name and buy a similar property under your limited liability company or LLC.
You must identify a new property within 45 days: As per IRC Section 1031(a), a seller has 45 days to identify the new property for exchange. Within this period, you must also notify the IRS regarding the new property. This gives them enough time to approve the exchanges.
The exchange process should be completed no later than 180 days: An investor will use this timeframe to finalize and complete the exchange process. By the end or within these 180 days, you must have done the closing of the new property to qualify for a 100% tax deferment. Failure to replace the property within 180 days may lead to paying capital gains taxes on your gains.
How Does 1031 Exchange Work?
In a 1031 exchange, you sell an investment property in cash, and your sale proceeds are placed in a qualified intermediary. When you and your intermediary have identified a replacement property or qualified exchange properties, you purchase them with the funds from your initial sale. The replacement property must be purchased within 45 days of closing on the original property.
It may sound easy, but the execution requires strict compliance with the IRS. That said, here’s how the 1031 exchange works.
Determine the Property to Buy & Sell
As mentioned earlier, the real estate for exchange must be "like-kind," meaning it must be similar but not necessarily the same quality or grade. For identifying the property for sale, you must also consider your tax basis, current mortgage, and market value. Note that properties outside the U.S. aren’t considered “like-kind” to properties inside the country.
Select a Qualified Intermediary
You need an intermediary or “exchange facilitator” because any money you get from the sale is considered capital gains and taxable income. Taking the money before the exchange is approved will be considered a disqualifying event, and you'll lose your eligibility for the capital gains exclusion.
In other words, you can’t exchange one property for another yourself. You need a qualified real estate professional or intermediary to do the 1031 exchange. Furthermore, you can’t pick someone who is your relative, attorney, or real estate agent or has performed any of these roles for you in the last two years. The intermediary person acts as a middleman for the exchange and holds on to the proceeds from selling your property while you search for a new replacement property.
Immediately Sell Your Chosen Property
After you have a trusted intermediary, selling your property as quickly as possible is the next step. Remember that the replacement period is only 45 days after selling. It would help if you acted quickly in selling your investment property, so you have ample time to find and transact for the replacement property.
Keep Track of the Replacement Period
Generally, there are two deadlines to keep an eye on. Once failed, the gain on the sale of your property may be taxable.
After you sell your home, you have up to 45 days to identify potential replacement property. You'll then have to submit a written notice of the new property to the proper authorities.
You have up to 180 days after you sell your old property or file your tax return, whichever comes last, to close on the new property.
Notify the IRS About the Transaction
Finally, don't forget to fill out IRS Form 8824. In the section marked "Description of the Transaction," you must provide the names and addresses of the people involved, property address, timeline, and explain the money flow.
When Should You Do a 1031 Exchange?
Many investors have found that the 1031 exchange gives them the flexibility to sell an asset and reinvest in another business or investment if they are considering selling or exchanging a property but feel that it doesn't have enough value to make a traditional sale process worthwhile, thinking about how a 1031 exchange can help you might be beneficial.
There are times when investors can defer taxes and take other critical advantages by structuring a property sale using the 1031 exchange rules. It’s crucial, however, to follow the tax requirements to ensure your real estate transaction is considered a 1031 exchange.
This tax code quickly shifts your focus from selling real estate to purchasing new real estate. This can make it easier to adapt to changes in market conditions. At least one day is required to identify the potential alternative property, and most exchanges need up to 45 days between identification and closing of the sale and purchase transactions. According to IRS rules, you cannot close on a new piece of real estate until at least 180 days after the sale closes.
The exchange allows you to roll over a deferred gain from one property into another similar or related property. The following scenarios represent ideal situations for a 1031 exchange investment.
Let’s assume you have a real estate investor with a property that underperforms. You can sell the property and use the proceeds to invest in another, which means you don’t lose on your initial investment; you get to enter a new opportunity with potential growth. If you have an investment property that you’re ready to move on from, you can reinvest the proceeds into another type of real estate that better suits your portfolio and goals.
A Property That Appreciated Substantially
Contrary to the first scenario, you own an investment property that has appreciated sharply in value over the last few years. For example, it has doubled the original purchase value you paid. That said, you want to take advantage of it by selling so that you can expand your portfolio. However, you can't afford to pay the capital gains taxes on your current tax bill. Then, you may be in a very fortunate position to use the 1031 exchange.
In both cases, you take full advantage of the said tax code. With the right 1031 exchange time frame, you can do all this while making your portfolio worth more!
Where Can You Find More Information on the 1031 Exchange?
The purpose of this article is to provide you with information regarding the tax deferrals that can be obtained through a 1031 exchange. However, the IRS’s guidelines on 1031 exchanges are one of the most confusing facets of a real estate transaction. You can find supporting information on the Internal Revenue Code website. If the process is still confusing to you, we recommend consulting expert professionals on such policies.
Many savvy investors view 1031 as the holy grail. They consider it a once-in-a-lifetime opportunity to defer tax indefinitely and get a step-up. While a 1031 exchange sounds simple on the face of it, it is ironically much more complex than many investors think.
To learn more about the 1031 exchange, rely on Pivot Professional Partners. Wherever you are in the U.S., you can set an appointment with us to help you easily navigate the 1031 exchange guidelines.
Disclosure: Please consult a tax professional for how a 1031 exchange can effect you.