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Continue1031 exchange rules enable investors to exchange like-kind properties and defer capital gains tax as part of their wealth building strategy.
The 1031 exchange is a powerful strategy employed by seasoned real estate investors to defer capital gains taxes on their rental properties. This approach allows investors to swap one investment property for another without incurring immediate tax liabilities.
However, successfully leveraging a 1031 exchange requires navigating specific rules and timelines that must be strictly followed to fully benefit from this tax deferral.
In this article, we will demystify the complexities surrounding 1031 exchanges, breaking down the essential elements in an accessible manner. Our goal is to empower you with the knowledge needed to make informed decisions regarding your real estate investments.
A 1031 exchange is a real estate strategy that allows a property owner to swap one investment property for another without incurring immediate tax liabilities. This strategy is also referred to as a like-kind exchange or Starker exchange.
Essentially, if the transaction complies with Section 1031 of the Internal Revenue Code, a 1031 allows you to change the form of your investment without cashing out and being subjected to capital gains taxes. In this way, you can defer capital gains on your property.
There is no limit on the frequency with which you can execute a 1031 exchange. Landlords can roll over capital gains from one piece of investment real estate to another indefinitely. Although each swap may yield a profit on paper, taxes are deferred until you ultimately sell for cash later.
When you do eventually sell though you will have to pay capital gain tax which will be at the long-term capital gains rates (currently around 15 – 20%).
The 1031 provision is for investment and business properties, however, the 1031 exchange rules can apply to a primary residence under particular conditions and you can also use a 1031 exchange for swapping out a vacation home – again if you meet particular criteria.
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The IRS outlines several requirements for rental property owners for a successful 1031 exchange aiming to defer capital gains taxes. Below are some of the key criteria and timelines associated with this process.
To qualify for a 1031 exchange, the property being acquired must be of "like-kind" to the property being sold.
According to IRS guidelines, like-kind properties are those that share the same nature or character, regardless of differences in grade or quality. This means that various types of investment or business properties can be exchanged, such as swapping a rental property for commercial real estate.
Notably, it is permissible to relinquish one property in exchange for multiple new properties.
It is essential that the same taxpayer is involved in both the sale and purchase transactions. If the names on the title of the relinquished property differ from those on the replacement property, the exchange will not be recognized by the IRS.
Only properties held for investment or business purposes qualify for a 1031 exchange. Recent changes in tax law have eliminated loopholes that allowed personal properties to be included in exchanges. Under current regulations, personal residences cannot be exchanged for investment properties, nor can investment properties be exchanged for personal use properties.
To achieve full tax deferment, the net market value of the replacement property must be equal to or greater than that of the relinquished property. This requirement also applies to any associated mortgages; both must match or exceed those of the sold property.
For example:
This scenario qualifies for full tax deferment.
Conversely:
This situation does not qualify.
The 1031 exchange process is governed by strict timelines:
Below is an overview of some of the advantages and drawbacks that come with using a 1031 exchange strategy to defer capital gain.
One of the most significant advantages of a 1031 exchange is the ability to defer capital gains taxes. By reinvesting the proceeds from the sale of a property into a "like-kind" property, investors can postpone tax liabilities, allowing their investments to grow without the immediate burden of taxation.
Exchanging a property with lower rental income for one with higher potential can lead to an immediate boost in cash flow. For instance, moving from an 8-plex to a larger multifamily property can enhance monthly or quarterly income, making it easier for investors to achieve their financial goals.
A 1031 exchange provides an opportunity for diversifying real estate holdings. Investors can transition into different types or sizes of multifamily properties, which can help mitigate risks associated with market fluctuations. This is particularly relevant in dynamic markets, such as when many loans are maturing in the multifamily sector.
By deferring capital gains taxes through a 1031 exchange, investors can continue to build wealth in real estate. This strategy allows them to acquire larger and potentially more profitable assets over time, increasing both portfolio value and rental income without immediate tax consequences.
One of the main drawbacks of a 1031 exchange is the strict identification period. Investors have only 45 days from the sale of their relinquished property to identify potential replacement properties. If they fail to do so, they risk losing the tax-deferral benefits entirely.
For businesses managing larger portfolios, identifying suitable replacement properties within the tight timeframe can be particularly challenging. For example, a company may struggle to pinpoint a $100 million asset within just 45 days after selling its previous property, especially if it typically invests only in its own deals.
Economic conditions can significantly impact the success of a 1031 exchange. For instance, rising interest rates can complicate the process by increasing borrowing costs and affecting property values. If interest rates rise sharply during the exchange process, it may become difficult to sell the original property and secure a new one within the required timeframe.
To fully defer capital gains taxes, investors must reinvest all net proceeds from the sale into the new property and incur debt equal to or greater than that on the sold property. This requirement introduces risks related to property valuations and debt alignment; if these factors do not align properly, it could jeopardize the entire exchange.
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Real estate investors commonly use five types of 1031 exchanges. These include:
It is important to note that during the identification and purchase of a replacement property, investors cannot receive funds from the sale of the property. The funds are instead held in escrow by a 1031 exchange intermediary, who cannot be someone who has previously acted as the exchanger's agent. To find a qualified intermediary, it is recommended to seek a referral from a broker or escrow officer.
A classic exchange involves a simple swap of one property for another between two people. However, the chances of finding a person who has the exact property you want when you have the exact property they want are pretty slim. Because of this, the majority of exchanges are third-party, delayed, or Starker exchanges.
In a delayed exchange you will need to find a qualified intermediary or middleman to hold the cash after you sell your property. You will then use that cash to “buy” the replacement. A three-party exchange is treated as a swap but with more than two parties involved.
There are two key times during the 1031 exchange process that you need to be aware of.
After 45 days of the sale of your property, you must inform the intermediary of the property that you want to acquire. The IRS says you can designate up to three properties as long as you close on at least one. You can designate more than three properties if they meet particular valuation requirements. For example, you are swapping one high-value property for multiple small value properties.
The second important timing requirement to note is 180 days. In a deferred exchange, you need to close on the new property within 180 days of selling your old property.
It’s important to note that the two time periods work in conjunction. Meaning you have 45 days to find the property you want, and a further 135 days to close.
Getting started with exchanges starts with finding a good facilitator. Because of the complications that can arise during an exchange, it’s important to find an experienced and qualified professional to help you navigate the process and handle legal complications.
You can obtain the names of facilitators from the internet, attorneys, CPAs, escrow companies, or real estate agents. Exchange fees typically range from $400 to $750. You may wish to obtain copies of the documents the facilitator will use for review by your attorney.
In order to successfully execute a 1031 exchange you will need to make sure the property you're looking to purchase is eligible under the 1031 exchange rules. You will need to identify the replacement within 45 days so it makes sense to begin looking before your begin the process.
According to the Internal Revenue Service, for a property to be eligible for a 1031 exchange it must be a like-kind property - meaning it’s of the same nature or character as the one being replaced, even if the quality is different. The IRS considers real estate property to be like-kind regardless of how the real estate is improved.
Additionally, the identified property should be of equal or greater value than the one you're selling.
You should have all the salient information ready to share with your facilitator. Not doing so will delay the process.
Typically the key information you need to structure an exchange is The Exchanger’s name, address, and phone number, and the escrow officer’s name, address, phone number, and escrow number.
However, having the following additional available so that the facilitator can properly review the exchange is a good idea:
And if you have them ready these details as well:
In general, a 1031 exchange is a great way to defer capital gains taxes meaning you have more cash right now to build wealth. There are a few additional important things to consider and further nuances to the aspects we have touched on in this article. Such as, if you want to use the property that you swap for as your primary residence you can’t do so immediately. To meet the safe harbor requirements in the period immediately after the exchange:
There are many complex parts of a 1031 exchange so even seasoned investors must enlist proper professional help to make sure the exchange is pulled off smoothly.
When a depreciated property is exchanged it can trigger the depreciation recapture process. In short, the depreciated amount used in tax deductions is then taxable as ordinary income rates.
In general, if it’s a direct swap of one property for another you can avoid the depreciation recapture, but there are scenarios where it might be applicable.
There are numerous such complications and nuances in the exchange process which is why it’s so important to get qualified professional help when you’re doing a 1031 exchange.
A reverse 1031 exchange is when you locate a property that you’d like to acquire before you find a buyer for your own property. Instead of waiting till you close on your relinquished property, you can make an offer.
In this situation, it’s common practice to make the purchase contingent on whether your property actually sells. If you close on the property you are selling before you close on the one you are purchasing the exchange works normally and is considered a delayed exchange.
If however, you decide you must close before you have a buyer in place for your relinquished property you can acquire it using a reverse exchange. Generally, this process is a little more expensive, however, it’s still fairly common as the buyer gets assurance that they will get the exact property they want, while still being able to defer capital gains tax when they sell their property in the future.
The like-kind 1031 exchange rule is central to managing a successful exchange. However, the term like-kind is a bit disingenuous in this context. It does not mean, as you might assume, a Single Family Home (SFH) must be exchanged for an SFH. Like-kind instead refers to the nature of the investment rather than the form. In this regard, it means any type of investment property can be exchanged for any type of investment property.
For example, an SFH can be exchanged for a triplex or duplex, raw land, or even a commercial rental property. In fact, as the exchanger, you could swap one high-value property for multiple small value properties even. Because of this, there is quite a bit of flexibility to run 1031 exchanges to develop your investment strategy.
You cannot, however, swap a different asset type, eg. a primary residence for an investment property. Nor can you trade partnership shares, bonds, certificates of trust, or other such items. Additionally, developments or refurbished and flipped properties are considered stock in trade and are not exchangeable either.
There are a few specific criteria that you must meet to qualify for a 1031 exchange.
You can exchange across state borders, this is actually very common. It is important though to note that there are variations in the treatment of taxes and local fees associated with each state so it’s a good idea to read up on those laws and regulations as part of the decision-making process before completing your exchange so that you don’t get caught out.
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