The 1031 exchange for real estate investors
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The 1031 exchange has been used by savvy real estate investors for decades. When properly executed, a 1031 exchange allows you to legally defer paying tax on investment gains when you sell a qualified property and purchase a replacement. What does this rule mean for investors? let's dive in.
What is the 1031 exchange?
The premise of this rule is simple. When you sell an investment property, you generally have to pay tax on the gain at the time of the sale. Internal Revenue Code (IRC) Section 1031 provides an exception. You can postpone paying tax if you reinvest in a “like-kind” investment.
The key difference is that you're exchanging rather than selling the investment. That's easy enough to understand, but there are strict IRS rules you must follow to make it work.
There's a lot of misinformation out there. I hope to clear up some of that in this article.
What is the IRC section 1031 exchange rule?
A 1031 exchange provides real estate investors with a key advantage offered by a traditional IRA or 401(k) investment plan: tax deferral. A transaction made within your retirement plan — selling the shares of a fund, for example — is not a taxable event. Tax on capital gains is deferred. You still keep the money within the plan account.
The same principle holds true for tax-deferred exchanges of real estate investments. As long as you keep the money invested in similar real estate assets (and you follow all the rules), your capital gains tax can be deferred.
What's the concept?
The concept is that the taxpayer is merely exchanging one investment property for another of “like-kind.” The taxpayer received nothing with which to pay tax. All gain is still locked up in the new property, so no gain is “recognized” for income tax purposes.
In a qualified retirement plan, you don't pay tax until you withdraw funds. Using a 1031 exchange, you don't pay tax until you sell the replacement property. And you can do another 1031 exchange on the same property down the road and again defer the tax.
Section 1031 and sale of real state property
Section 1031 is most often used in connection with the sale of real estate property. But some personal property exchanges also qualify under Section 1031.
Consult with an expert because exclusions were added in 2018. Types of property now specifically excluded from Section 1031 eligibility include business partnership interests and assets such as inventory, machinery, equipment, vehicles, and intangible business assets such as intellectual property.
Qualified intermediaries and executing a 1031 exchange
All Section 1031 financial transactions must go through the hands of a Qualified Intermediary (QI).
The intermediary holds proceeds from the sale and then disburses that money at the closing of the exchanged property. In order to qualify, the cash proceeds from the original sale must be reinvested toward acquiring the new property. Any cash retained by the taxpayer/seller from the sale of the old property is a taxable gain.
The intermediary is considered qualified by the IRS because he/she is an independent party with the sole purpose of facilitating the exchange process. You cannot act as your own facilitator. Nor can your agent act as your intermediary. (“Agent” includes your real estate broker, investment banker, accountant, attorney or anyone else who has worked for you in one of those capacities within the previous two years.)
A 1031 exchange typically works like this: At the close of the relinquished property sale, the proceeds go directly to the QI. The QI holds the funds until the transaction for the replacement property acquisition is ready to close. Then the QI sends the proceeds from the sale to purchase the replacement property. After the acquisition of the replacement property closes, the QI delivers the property to the taxpayer. All these proceeds without the taxpayer ever having what the IRS calls “constructive receipt” of the funds.
The properties must be “like-kind” to qualify
IRC Section 1031 allows you to defer tax on gains only if you reinvest the proceeds in a similar or “like-kind” property. Like-kind means the same in nature, character, or class. Quality or grade doesn't matter.
Most real estate will be like-kind to other real estates. But exceptions exist. For example, real estate property located within the U.S. is not like-kind to property outside of the U.S.
There are other rules related to “like-kind.” For example, property for personal use does not qualify. This includes your primary residence, second home, and vacation home. (See below regarding what qualifies as a vacation home.)
To ensure you proceed properly, check with an expert regarding all the rules.
Timing is everything
A like-kind exchange does not have to be a simultaneous swap of properties. But you must meet two deadlines or the entire gain will be taxable. These deadlines cannot be extended for any circumstance (except in the case of presidentially declared disasters).
First, you have 45 days from the date you sell the relinquished property to identify potential replacement property. This is known as the identification period. The identification must be in writing, signed by you and delivered to your QI or the seller of the property. Giving notice to anyone acting on your behalf in any part of the transactions is not sufficient.
During this identification period, you have three options in finding your replacement property. You can either:
- Identify up to three properties as potential purchases; or
- Identify any number of replacement properties as long as their total value doesn't exceed 200% of the value of the property being sold; or
- Identify as many properties as you like as long as you acquire properties valued at 95% or more of their total.
Regardless of how many properties you identify, you must clearly describe these replacement properties by street address or legal description.
The second deadline is the exchange period. The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property.
So to successfully complete a 1031 exchange, a taxpayer must identify the replacement property within 45 days of closing on the sale of the original property and acquire the replacement property within 180 days of that closing. This ensures the continuity of investment as required by the IRS.
Types of 1031 exchanges
- Simultaneous Exchange — A simultaneous exchange is a swap of the relinquished property with the replacement property that happens at the same time. This is rare simply because it's nearly impossible for everything to happen at the same time when you're talking about two separate transactions as complex as real estate transfers.
- Deferred Exchange — In the more common deferred exchange (also referred to as a forward exchange), the disposition of the relinquished property and acquisition of the replacement property are mutually dependent parts of an integrated transaction facilitating the exchange of property.
- A reverse exchange is when the investor acquires the replacement property before transferring the relinquished property.
- Construction Exchange — A construction exchange is when a taxpayer uses some of the sale proceeds of the relinquished property to improve the replacement property. Construction must finish prior to the normal 180-day limit. This time restriction makes this type of 1031 exchange difficult for most investors to use.
How depreciation works with a 1031 exchange
The tax benefit of depreciation allows real estate investors to recover the cost of a property over a predetermined life. In a 1031 exchange, you replace that property with a new property. If the replacement property is the same value, you continue your depreciation calculations as if you still own the old property.
If the replacement property is of greater value, you treat the extra amount as you would the cost of construction to the old property (like an addition that improves the value). The depreciation method you use is the most appropriate for the replacement type of property.
Types of properties that qualify… and don't qualify
To qualify as a Section 1031 exchange, a deferred exchange is different from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction).
Both the relinquished property you sell and the replacement property you buy must be held as investments. This means they either generate income, such as a rental property, or are expected to increase in value, such as vacant land that you intend to sell later for a profit.
Property used primarily for personal use does not qualify for like-kind exchange treatment. This means your primary residence or a second home does not qualify.
A vacation property may qualify for a 1031 exchange under some circumstances:
You rent the home at fair market value (FMV) for at least 14 days per year, and
You, your friends, and relatives use the home no more than 14 days per year or 10% of the number of days it is rented at FMV, whichever is greater. (“Friends and relatives” in this case refers to people who do not pay FMV. If they pay FMV, those rental days fall under #1 above.)
Other limitations exist. So check with an expert before you assume your vacation rental qualifies.
Taxpayers who purchase real estate for resale (flippers) are considered “dealers” and cannot use Section 1031 to defer tax, even if they're rolling the gains into their next flip.
Your gain is tax-deferred, not tax-free
As mentioned earlier and very important to remember: When you use a 1031 exchange, you postpone the tax because you are exchanging one similar asset for another. That helps your current cash flow, but your gain will eventually be taxed when you sell the new property.
There's a silver lining: There's no time limit for holding the property. You can defer tax as long as you still own the property. And you can do another 1031 exchange on the same property down the road and again defer the tax, as long as you're exchanging like-kind properties and following all the rules.
You don't even have to sell the property in your lifetime. You can pass it on to your heirs at which time
A few words of warning
The IRS warns that you should be wary of individuals promoting improper use of like-kind exchanges. Some educational materials and internet sales pitches propose that a vacation home automatically qualifies for the 1031 exchange.
Promoters of like-kind exchanges often refer to them as “tax-free” exchanges, rather than “tax-deferred” exchanges. And they may even advise you to claim an exchange despite your having already taken possession of cash proceeds from a property sale.
Don't fall for misinformation about doing a 1031 exchange. Find an experienced QI before you do anything.
And it's crucial to remember that failure to comply with the deadlines and all the rules will result in a failed exchange. For example, if you take control of cash or other proceeds before the exchange is complete, the entire transaction of like-kind exchange treatment is disqualified and all gain is immediately taxable. You might even be held liable for penalties and interest on your transactions.
I highly recommend you use an expert when doing an IRC Section 1031 exchange.
A stress-free way to do a 1031 exchange
Online real estate platforms have been revolutionizing the way investors buy property. Many of these platforms allow you to buy shares of both commercial and residential property with a relatively small minimum required investments.
But what you may not know is that some of these platforms allow you to defer your capital gains tax when swapping out investments, thanks to a 1031 exchange.
Here's a list of the real estate platforms we've reviewed that offer this feature:
Disclaimer: I've distilled this article content by studying the IRS publications, researching important cases supporting the tax law, and consulting with a few experts. However, I'm neither a tax accountant nor a lawyer, so the points in this article should not be considered tax advice. Properly executing a 1031 exchange is an involved process. Be sure to reach out for professional help and find a reputable QI before you begin the process.