A 1031 Exchange is an extremely powerful tax deferral strategy used by some of the most successful real estate investors. Also called a Like-Kind Exchange, you’re probably hearing a lot about 1031’s right now for two reasons. Because they may go away in the near future depending on which administration wins the election in Washington and because in several U.S. cities real estate prices are bloated. This is causing investors to think that now is the right time to exchange properties in bloated markets for better priced markets around the country
Let’s take a look at what a 1031 exchange is, how to execute it, and the rules that go with it.
What is a 1031 Exchange?
This strategy gets its name from section 1031 of the IRS Code. Using a 1031 Exchange allows investors to defer paying capital gains taxes on an investment property at the sale as long as another “like-kind property” is purchased with the profit gained by the sale of the first property. This allows the real estate investor to move the gains to another replacement property without incurring any tax liability owed to the IRS.
When you sell an investment property, you’ll have to pay capital gains tax unless you use this strategy. If you own a rental property that is worth far more today than what you purchased it for, you can do very well with a 1031. So – how do we actually do this?
How To Execute a 1031 Exchange
You must exchange one property for another property of the same or greater value. It must be like-kind (ex: real estate for real estate). This is a huge tool for real estate investors and the tax reformers in Washington would like to see it removed.
The exchange rules require that both the purchase price and the new loan amount be the same or higher on the replacement property. If an investor were selling a $5 million property in New York that had a $2 million dollar loan, they would have to buy $5 million or more of replacement property with $2 million or more in debt attached to the purchase.
What Are The 1031 Exchange Rules?
There are 7 general 1031 Exchange rules.
- like-kind property: Like-kind means that the original property and the replacement property are of the same nature. you can’t trade in a boat for an office building. You can exchange almost every type of property except personal property, including vacation homes. Apartment Buildings, single-family properties, retail, industrial – it’s all on the table. And make sure it’s inside the US. Don’t try swapping to a building in Canada and hope for the same perks of the American IRS code. Another good piece of information is that you can use more than two properties in this exchange. You can take a small portfolio and sell them all as long as the replacement property is greater than the value of all the properties you’re trying to use in the 1031 exchange. Use a qualified intermediary to make sure you don’t make a misstep.
- Investment or business purposes only: You can’t use a primary residence or personal property like a vacation home. Business property only. This can go from state to state as well. You can sell a single-family rental property in Ohio for a commercial rental property in New Jersey.
- Greater or equal value: To be able to have a tax deferral, the IRS needs the market value of the new property to be the same as or greater than the property (or multiple properties) you are selling.
- Must not receive “boot”: If your new property is less expensive than the existing property you are selling, the gains are known as “boot”, which you will have to pay capital gains tax on. this would be a partial 1031, which is ok if you want to pull some cash out and don’t mind taking the tax hit.
- Same taxpayer: The title for the property being sold and the new property being acquired need to be the same taxpayer or have the same tax return. This is important. Sole member LLC’s can sell a property to the taxpayer that is the sole member. “Great Deals LLC”, owned by Mike Jones can 1031 a new property to the individual Mike Jones because Mike is the sole member of Great Deals LLC, so it satisfies the IRS code.
- 45-day identification window: Once you close on the old property, the property owner has 45 calendar days from the day of close to identify a new property. There is a rule called the 200% rule. If you can’t find one larger deal that makes sense and fits the IRS code, you can purchase 4 or more properties as long as it does not exceed 200% of the value or the property that you sold.
- 180-day purchase window: After the sale of the original property, you have 180 days (6 months) to close on the replacement property or the due date of the tax return for the tax year that the relinquished property had been sold, whichever one comes first.
Hopefully, you now understand the basics of a 1031 exchange. Real estate investing full of opportunities where using real property and depreciation recapture can use the tax code to your advantage and cut down on your tax bill.
We fully recommend seeking guidance and not trying to do this on your own. The pro will help you to not make a misstep on your deferral and end up getting caught paying capital gains taxes. There are a few different types of exchanges that we’ll talk about in the future. The reverse exchange, simultaneous exchange, delayed exchange and improvement exchange.
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