If you’re in the real estate investing game, then you are likely familiar with the concept of a 1031 exchange rule: an IRS-approved method of deferring capital gains taxes on a piece of property when selling and reinvesting those proceeds into another property.
What is a 1031 Exchange?
A 1031 exchange is a tax-deferred exchange of one property for another – it’s not taxed until the property is sold. And under Section 1031 of the Internal Revenue Code, you can defer taxes on any gain from selling an investment property by reinvesting all or part of the proceeds into another investment property before December 31st of that same year (or before June 15th in some cases).
The History of 1031 Exchanges
The 1031 exchange has a long history, and it was created in an effort to help the economy. The Revenue Act of 1921 was passed by Congress and signed into law on February 26th, 1921 by President Warren G. Harding.
The act created Section 1031, which allows taxpayers to defer capital gains tax on the sale or exchange of property if they reinvest their proceeds in another similar property within 180 days of the first sale or exchange.
The origin of 1031 exchanges is rooted in two goals: encouraging investment into real estate, and helping those who want to invest but aren’t able to do so due to lack of resources (i.e., most people). Since its inception, 1031 exchanges have proven successful at increasing investment in residential and commercial properties across the country—and we’re still seeing that trend today!
Who Can Qualify for a 1031 Exchange?
If you are thinking about doing a 1031 exchange, there are several important things to keep in mind. First of all, you must be a US citizen or resident alien. Additionally, the entity or entities involved in the transaction must be non-corporate entities (e.g., sole proprietorships, partnerships) or corporations that are not classified as C corporations (i.e., S corporations and LLCs).
What Property Can Be Exchanged?
There are many types of property that qualify for a 1031 exchange. They include:
- Real estate (i.e., land, buildings, or interests in real estate).
- Personal property (i.e., patents, copyrights, and other intangible assets).
- Business interests (including operating businesses and investment properties).
- Land improvements like landscaping, fences and roads that you own.
You must also consider whether your replacement property is eligible for a 1031 exchange as well.
Types Of 1031 Exchange
With all the different kinds of 1031 property exchanges available, you can modify your strategy to work for your specific situation. But which exchange is right for you? Here’s a brief summary of each and how they’re used:
1. Simultaneous exchange
Simultaneous exchange is the most common type of 1031 exchange. In this type of exchange, you sell property and buy replacement property at the same time. This is a “simultaneous” process because it happens all at once rather than taking place over several months (as in an installment sale or delayed exchange).
You can do this if you have enough money to buy replacement property and do not want to go through the hassle of finding tenants for your old property while you wait for your new one to be ready.
2. Delayed exchange
A delayed exchange is an exchange of like-kind property for like-kind property. This type of 1031 exchange is allowed to be delayed for up to 180 days after the sale of the relinquished property.
In a typical delayed exchange, you sell your relinquished property (the one you want to convert into cash). Then, with the proceeds from that sale, you purchase a replacement property (the one where you will live).
You continue to live in this new home without paying rent until the new year begins—at which point it becomes time for another tax year.
3. Reverse exchange
While a reverse exchange is relatively rare, it’s worth mentioning here. A reverse exchange is when you sell your property and use the proceeds to buy a new property. However, unlike in an indirect exchange (see below), the new property must be of equal or greater value than the old property.
This means that if you sold an office building for $3 million and bought another one for $2 million, you would have to find another way to get rid of that difference somewhere else. In other words: no tax-free gain for you!
There are two ways to complete a reverse exchange:
- You can sell one piece of investment property, then purchase another piece within 180 days using all of those proceeds. Or…
- You can sell two pieces of investment property within 180 days—one after the other—and use those combined funds plus any additional cash from other sources as down payment on your replacement properties.
4. Improvement exchange
An improvement exchange is used to exchange property for property of equal or greater value. This type of exchange is the most common, and it can be used to buy a new property or an existing property.
When you sell your primary residence and use the proceeds to purchase a new home, this is an improvement exchange. The sale of a business also qualifies as an improvement exchange if you reinvest in another business within 45 days of selling the first one.
When you are looking into your options for buying real estate through 1031 exchanges, it’s important to understand exactly what kind of property you want to buy before deciding which type of exchange will work best for your situation.
5. Construction/rehabilitation exchange
A construction/rehabilitation exchange is used to exchange properties that are under development or have recently been constructed, but have not yet been placed in service. The property being exchanged must be a like-kind property. However, it does not need to be an identical property as long as it has the same character and uses.
The requirements for this type of 1031 Exchange are:
- The replacement property must be residential or commercial real estate, including any improvements on the land such as buildings or other structures.
- The replacement property must be located in the United States and within the same state where you hold title on both properties (i.e., California). If your original and replacement properties are located in different states, you’ll need to complete two separate transactions — one with each state — which can get complicated quickly!
- You must follow certain procedures when disposing of your original investment property before buying a new investment property through an exchange; if done incorrectly, your deal could end up being invalidated by IRS regulations
Benefits of a 1031 exchange
A 1031 exchange can be beneficial in a variety of ways like; defer capital gains, increase your capital, etc. Let’s take a look at four benefits:
1. A 1031 exchange is a way to defer capital gains taxes.
A 1031 exchange helps you defer paying capital gains taxes. This means that you don’t have to pay those taxes until you sell the property. If your investment property does well and increases in value, it’s possible to use a 1031 exchange to reinvest the proceeds from a sale into another investment property without having to pay any additional tax on those profits.
It’s important to note that when selling an asset for deferred capital gains treatment, the IRS requires that all parties involved must be part of a like-kind exchange (like two properties).
2. You’ll have more capital to reinvest.
You’ll have more capital to reinvest. You may not be able to use all of the money you save on taxes to reinvest in another property, but it certainly makes sense to put as much of it back into real estate as possible. There are plenty of other options for using that cash too, though!
Consider investing in other assets such as stocks or bonds (especially if your 1031 exchange funds came from stocks). If you don’t want to take on additional risk, paying off debt is another option. Finally, if there’s any left over after all those things have been taken care of, saving for retirement isn’t a bad idea either.
3. More leverage which gives you more buying power.
A 1031 exchange allows you to buy a larger property than you would be able to with cash. Consider this example:
You have $50,000 in cash that you want to invest in buying another property. A single-family home for sale in San Francisco costs $1 million and has a down payment requirement of 30%. After paying for closing costs and other expenses, there will only be about $500k left for the down payment on this property.
The seller is not willing to accept less than full asking price because they don’t have time to go through multiple rounds of offers.
So what can you do? You could take out a mortgage with your lender (this would require more paperwork) or borrow money from family members. But neither option is ideal because they require additional time and effort before any money can be put towards repairs or renovations needed after purchase day!
4. A 1031 exchange can help you grow your portfolio.
With a 1031 exchange, you can reinvest the profits from one property sale into another property or combination of properties.
For example, let’s say you sell an apartment building for $1 million and buy a house with those proceeds. You may not have been able to afford both at once if you didn’t have access to cash from selling your existing property to pay for it. But now that money can be used as down payment on the new home instead!
Similarly, if you sold an apartment building with five units and bought another unit in the same complex (or even one next door), this would still count as “like-kind.”
What are the possible problems with a 1031 exchange?
Although a 1031 exchange is an extremely useful tool for the right owner, it’s important to know its potential problems so you can make an informed decision before beginning this process.
Let’s take a look into 6 disadvantages of a 1031 exchange;
1. Tax liability does not disappear.
The three-year statute of limitations applies to your tax liability, but it doesn’t mean that the IRS won’t be able to audit you. Even after a 1031 exchange is complete, the IRS can still audit you and assess penalties if you didn’t report all of your income or failed to file or pay taxes properly.
2. Acquisition of like-kind replacement property can be complicated.
To qualify for tax deferral, you must identify the replacement property before the exchange is completed and close on it within 180 days after completion. The value of the replacement property cannot exceed that of the relinquished property; otherwise, you’ll need to pay tax on any gain after 180 days from completion.
It’s also important to note that if you buy more than one piece of real estate during a 1031 exchange, they all must be sold together as one parcel or as part of a group effort.
In addition, if you’re acquiring investment properties through a 1031 exchange—as opposed to rental properties—you won’t be able to deduct points paid on mortgages or other costs related directly to acquiring those properties until they’ve been held for at least 24 months following their purchase date (or longer if you elect out under Section 1(h) of 26 U.S Code §1031).
3. Additional tax problems from the exchange.
The 1031 exchange, while designed to be a tax-advantaged way of selling a property and buying another, can lead to a host of tax problems. The most common problem is the improper use of Section 1031 exchanges. This occurs if you;
- fail to structure the sale correctly
- are not careful when completing your tax return
- are not informed about how to execute an exchange correctly
- are negligent in your dealings with the IRS after executing your purchase and sale agreement
- are dishonest (failing to disclose all assets).
4. Delay in acquiring replacement property.
A 1031 exchange is a process that can take time and patience, so it’s important that you don’t wait too long without taking action. If you do, the most likely outcome will be that you’ve missed out on an exchange opportunity—and if this happens, it could mean having to pay taxes on any gain from your investment property.
In addition, if a buyer buys your replacement property before yours sells (or when it does sell), they’re going to charge you rent until then—which means even more money spent!
It’s also worth noting that many investors see their chance at a successful 1031 exchange as dependent upon finding their replacement property within six months of selling their old one. After all, with each passing day comes another day’s worth of equity growth and so much more potential tax liability down the line.
5. Replacement property may have a lower basis than relinquished property.
If you are thinking about selling your investment property and using a 1031 exchange to reinvest the proceeds into another of equal or greater value, you might have concerns about how much tax you will owe. One issue that may come up is that the new replacement property’s basis could be lower than your relinquished property’s basis.
If this happens, there won’t be any capital gain when you sell the replacement property in a future year (assuming it is held for more than one year).
On the other hand, if the replacement property has a higher basis than what was reported on your original purchase contract for your relinquished property, then there could potentially be taxable gains when you sell it someday in the future (again assuming it’s held for more than one year).
6. 1031 exchanges are complicated, time consuming, and require an attorney.
A 1031 exchange requires an attorney and their fees can be expensive. The attorney must be familiar with 1031 exchanges, as well as the rules for them in the state where the property is located (if you’re moving from one state to another).
To have a successful 1031 exchange, you must understand it very well to avoid some potential issues. You should also try to know the rules, even if not very well. This could help you in properly navigating your way through any of the exchanges.