Savvy real estate investors use a 1031 exchange as a powerful wealth-building tool to defer paying tax from the sale of qualified property.
The premise is simple – you have to pay capital gain tax whenever you sell a property at a gain; with a 1031 exchange, you don’t have to because of the exception provided under section 1031 of the IRS code.
In this article, you’ll learn how this powerful tax-deferment strategy works, the rules for 1031 exchange, and how to use it as a tool to keep building wealth without having Uncle Sam claim a huge portion of your real estate gains.
What Is A 1031 Exchange?
A 1031 exchange is a section of the income tax act (section 1031) that allows you to defer paying taxes on gains from a property you sell as long as you purchase a “like-kind” replacement property using the proceeds from the sale of the relinquished property.
It’s like swapping properties without having to pay taxes.
In essence, the proceeds from the sale are transferred into the replacement property. The owner does not receive any cash from the property exchanged because all the proceeds must be reinvested into the new property or properties.
This means, if you own real estate that you want to sell, section 1031 allows you to defer capital gains resulting from the sale of your property if you use the proceeds to buy another investment property of equal or higher value and if you follow specific rules.
It is a real estate investor’s favorite tool to build significant wealth in real estate; some people even use the term as a verb when they say, “let’s 1031 this property for than one”.
Why do real estate investors do a 1031 exchange?
Whether we want it or not, whenever we make money, Uncle Sam wants their share. So, if you’re selling an investment property that you own, chances are you’re going to have significant taxes due, such as capital gain taxes and depreciation recapture.
With a 1031 exchange, you can continually roll over tax obligations until you pass away, all while increasing your net wealth using Uncle Sam’s share.
But exactly what taxes can you defer with a 1031 exchange?
Capital gain tax
If you sell a property for $500,000, but you bought it for $300,000, the $200,000 gain is subject to capital gain taxes. Thus, you could end up having to pay Uncle Sum tens of thousands of dollars, which you could otherwise defer using a 1031 exchange.
It is common practice for real estate investors to deduct depreciation expenses from rental income. If you sell the property for a higher amount than the undepreciated amount, you have to pay back the tax deductions you previously took.
That can amount to a big chunk of change, but again, with a 1031exchange, you can defer those tax payments well into the future as long as you follow a specific set of rules.
Rules For A 1031 Exchange
The best way to plan a successful 1031 exchange is, hire a competent intermediary and don’t touch any of the cash coming from the sale of the property you’re selling.
Having said that, there are seven main1031 Exchange rules that you must follow. These include the following:
1031 Exchange Rules You Need To Know
1. The Rule of 45 Days And 180 Days
After the sale of the relinquished property has closed, you have a timeframe of 45 days to identify a replacement property and a total of 180 days to close on it.
Particularly the 45 days rule means you have little time to look for and make a successful offer on a property, which often can lead to making errors, such as buying the wrong property or for a price that’s too high.
To avoid the risk of not meeting this 1031 exchange timeline, I recommend you start looking for the replacement property from the day you decide to sell your existing property.
2. You Must Reinvest All The Cash Resulting From The Exchange
To achieve a tax-free deal, the transaction must be a like-kind exchange; A like-kind exchange means you sell your real estate property and buy another one, but you don’t pocket any cash at the end of the exchange.
For example, if you sell a property for $1 million and buy another one for $900,000, that means you’re pocketing $100,000 capital gain. You’ll need to pay capital gain tax or “boot” on the gain that is not reinvested into the new investment.
Every dollar of “boot” (amount not reinvested) is a dollar of taxable gain.
3. The Value Of The Replacement Property Must Be Equal To Or Higher Than The Relinquished Property
One question investors ask a lot is, “Do I have to purchase a replacement property equal to my sales price or just the amount of my capital gain?”
If you want to defer all the capital gains on the sale, the replacement property must be of equal or higher value, and you have to keep the real estate investment for at least a year.
4. Properties Must Be Used For Investment Purposes
To qualify for 1031 tax deferral, the property must be help for investment or business purposes. So, if you own a home that you use for personal use, it does not qualify for like-kind exchange treatment.
5. The Legal Owner For Both Properties Must Be The Same
For a 1031 exchange to work, both the sold property and the replacement property must be owned by the same taxpayer. Often, though, when more than one person owns properties, partners may have a different view of what to do with the sale proceeds.
So, if a company owns a property, sells it, and starts a 1031 exchange process to purchase a replacement, the same company must purchase the replacement property instead of an individual shareholder.
Similarly, if you purchased the property through an LLC, the same LLC should purchase the new investment.
6. Up to 3 properties or 200% rule
You can identify up to three properties as a replacement. However, if more than three properties must be identified, you can choose to use the 200% rule. Under the 200% rule, you can identify as many properties as you want, but the total value cannot be higher than 200%.
No matter which rule you choose to use, you must indicate whether you’ll be using either the “up to 3 properties rule” or the “200% rule”.
Read More: What is a Kind-Like Property?
Four Types Of 1031 Exchange
There are four types of like-kind exchanges available. These are the following:
- Simultaneous exchange,
- Delayed exchange,
- Reverse exchange
- Construction or improvement exchange.
1. Simultaneous Exchange (Same day close)
A simultaneous like-kind exchange takes place when you close on the purchase and sale of properties on the same day with the intent to defer resulting tax payments.
If you cannot close either the purchase or the sale on the same day, it’s a delayed exchange.
2. Delayed Exchange (Sell first, buy later)
Delayed exchanges account for 95% of all 1031 exchanges because it gives investors the greatest flexibility. You sell your property first and then use that money to buy a replacement property later.
The proceeds are deposited with a qualified intermediary who holds the funds until you buy the replacement property. The funds from the sale are then transferred into the replacement property.
3. Reverse Exchange (Buy first, sell later)
If you purchase the replacement property before selling the property being exchanged, that’s a reverse exchange. In other words, with a reverse 1031 exchange, you buy the replacement property before selling the relinquished property.
When you’re in a hot market, this could be a good strategy because you can take the time you need to find the right investment and then proceed to sell the property you want to sell.
4. Construction Or Improvement Exchange
(Use funds to improve a property)
With a construction or improvement exchange, you’re actually allowed to use 1031 exchange dollars to build or improve a property.
For example, if you sell a property for $1 million and buy a replacement property for $950,000, you can use the remaining $50,000 to improve the property.
However, the following conditions must be met:
Types Of Properties That Qualify For A 1031 Exchange
Not all property qualifies for a 1031 exchange. Only like-kind properties can be exchanged. Like-kind properties are properties of the same nature or characteristics, not including the property’s quality or grade.
For instance, you can exchange vacant land for a building or a commercial building for a rental house. However, you can’t exchange personal property such as furniture or a car. Also, you can’t1031 exchange properties for personal use; it has to be for investment or business purposes.
Restrictions Of A 1031 Exchange
The determining factor that drives whether a property qualifies for a 1031exchange is that the property must be purchase for investment or business purposes. Properties used for personal use do not qualify.
Nevertheless, investors wishing to utilize section 1031 must consider the following additional restrictions.
- Properties being exchanged must be for investment purposes.
- Whenever the seller receives cash, it may result in tax payments.
- Once you sell the relinquished property, you have 45 days to identify the replacement property and 180 days in total to close the transaction.
- The replacement property must have an equal or higher price, or you will pay taxes on the price difference.
How To Structure A 1031 Exchange?
To structure your 1031 exchange property, you’ll need to work with an expert.
You don’t want to get surprises later on; so, hire the best 1031 exchange intermediary firm in your area.
You want to maximize the benefit that a 1031 exchange gives you. To do that, your replacement property must have an equal or greater value than the property you are selling. Also, you must identify the replacement property within 45 days after the sale transaction, and you must close on the exchange within 180 days.
Thankfully, a 1031 exchange intermediary can help you structure each step the right way. The intermediary will hold the sale’s net proceeds until you have to pay for the replacement property.
The way it works is, after the property being exchanged is sold, the intermediary holds the funds in an escrow account and uses those funds to pay for the replacement property’s purchase price and closing cost. Any money left that’s allocated to the taxpayer will become a taxable amount.
1031 Exchange FAQs
Does my property qualify for a 1031exchange?
Any real estate property held for investment or business purposes qualifies for a 1031 exchange; this means your primary residence does not qualify.
Can you use a 1031 exchange to purchase a primary residence?
Section 1031 gives you tax deferral of capital gain taxes. Gains on the sale of a property that qualifies as your principal residence are tax exempt. Also, 1031 exchange properties must be held for investment purposes.
Thus, you cannot use a 1031 exchange to purchase a principal residence. The rule of thumb is that you should not live in a 1031 exchange property, although there are some exceptions to that rule.
Is it possible to buy a 1031 exchange property for a lower value and pocket the remaining cash?
Yes, that’s possible. A 1031 exchange is not an all-or-nothing transaction. The amount that is not reinvested in the replacement property will become a taxable gain. Whenever the seller receives cash, it’ll give rise to boot (taxable capital gain).
What expenses can be paid using 1031 exchange funds?
You can use 1031 exchange funds to pay for other expenses, in addition to the purchase price of the replacement property. These include:
- Real estate commissions
- Fees paid to the intermediary
- Filing fees
- Legal fees
- Title insurance premiums
- Escrow fees
Here is a list of expenses that cannot be paid using 1031 exchange funds:
- Property taxes
- Insurance premiums
- Repairs and maintenance
- Financing costs
Is it possible to 1031 exchange one property for multiple other properties?
Yes, it is possible to exchange one property for multiple properties. It does not matter how many replacement properties you acquire as long as the total value is equal to or greater than the relinquished property.