What's a 1031 Exchange and why does it benefit investors?

If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. It's a specific method which allows the owner of an investment property to sell it and buy a like-kind property while deferring the payment of capital gains tax. So if you're daydreaming about being the next "fix and flip" success in your town, it pays to know what this very special tax treatment is all about.

1031 Exchange

The term 1031 exchange comes from the IRC Code Section 1031 which says that when you sell a business or investment property and you have a gain on the sale, you can reinvest the proceeds of the sale on a similar property to defer paying taxes on the gain, thereby avoiding capital gains tax on real estate investments. For a 1031 exchange to occur there must be an exchange of properties.

Rules of a 1031 Exchange

There are many rules to follow and failure to follow these rules can trigger significant capital gains taxes, penalties and interest. These rules state:

  • The exchange must be with a like-kind property. This is a broad definition and in real estate typically means exchanging almost any type of property (for investment or business) as long as it is not personal property. You can even exchange one property for multiple properties as long as the new properties are similar to the one being sold. Note: the property must be in the U.S. to qualify.
  • The replacement property must be of equal or greater value in order to completely avoid paying taxes on the gains of your sale. Otherwise, you will not be able to defer 100% of the tax.
  • The exchange must occur with the same tax payer — in other words the name on the Title of the property being sold and the name on their replacement property must be the same as the name on the tax return. The exception to this is a single member limited liability company may sell the original property and the replacement can be purchased by the sole member in their individual name.
  • The property owner has 45 days after closing on the first property to identify up to three potential properties of like-kind. You can identify four or more properties if the value of those four combined does not exceed 200% of the value of the property sold. Note: the replacement property must be described in writing.
  • There is a 180-day purchase window for the completion of the exchange. Note that these time limits typically can not be extended except in cases of President-declared disasters.

1031 Exchange for Real Estate investors

There are Four Types of Exchanges for Real Estate

  1. Simultaneous Exchange: occurs when the replacement property and original property being sold close on the same day. Any delay can result in disqualification of the exchange. This can be done with a simple two-party swap, or having a middleman handle the exchange when it’s a different person selling you the replacement property than buying your property.
  2. Delayed Exchange: the most common type of exchange, which occurs when the original property sells before finding a replacement property. This requires a third-party exchange facilitator to hold the proceeds from the first sale in a binding trust for up to 180 days while the seller acquires replacement property (by using exchange agreements that follow rules provided by the Income Tax Regulations). With this strategy, there is a max of 45 days to identify the property and 180 days to close.
  3. Reverse Exchange: occurs when you acquire a replacement property through an exchange accommodation titleholder before you sell your relinquished (old) property. Note: many banks don’t offer loans for this type of exchange. The same rules apply as the delayed exchange — 45 days to identify the property and 180 days to close.
  4. Construction Exchange: allows taxpayers to make improvements on the replacement property by using the tax-deferred equity from the exchange. The entire proceeds must be spent on completed improvements or as a down payment within the 180 days, the property must be identified within 45 days of closing the original property, and the replacement property must be equal or greater value when it is deeded, with the improvements in place before the taxpayer can take the title from the third-party intermediary.

Types of Properties Excluded from the 1031 Exchange

  • Stock in trade
  • Stocks, Bonds or Notes
  • Securities or Debt
  • Certificates of Trust
  • Partnership Interests

As you can see, there are a lot of rules when doing a 1031 Exchange and some risks that go along with it as well, but there are huge benefits if you know which market will grow in the future. This allows you to shift your investing methods periodically throughout your life. Choose your replacement properties wisely. If you own a rental property that is worth more now than when you purchased it, this strategy may work well for you. Buying a fix and flip or being labeled a “dealer” probably won’t work so well because it may be considered “stock in trade,” making it ineligible for a 1031 Exchange.

And finally, one of the biggest benefits of using 1031 Exchange (if you continue to always trade up for increased value and still hold the properties when you pass away) is that the cost-basis of the last property will be adjusted to its current value and your heirs will not be liable for the accumulated capital gains taxes. With the 1031 Exchange, you avoid capital gains tax until you actually sell without an exchange. If you partake in a 1031 Exchange, you'll just have to report it to the IRS on Form 8824 on your tax return for the year in which the exchange occurred.

For more information, visit the IRS website here.

Want more advice about all things home — including homebuying or selling advice? Nestiny is a great place for homebuyer education and to help you gauge how ready you are to buy a home. Journey Homeward allows you to enter all your wants and needs while the True Affordability Tool will break down your budget, showing what you can comfortably afford. You will also receive a Ready Report that will give you a vital head start in the home buying journey, saving you valuable time and money.

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