Like-kind 1031 exchanges are widely used by real estate investors to create and preserve wealth. In simple terms, §1031 of the US tax code allows you to defer paying capital gains taxes, and what’s called "recapture" on the profits from selling a property, provided they are “exchanged” (i.e., reinvested) into another like-kind property.
Sound interesting? Here’s the catch. The IRS has strict rules and timeframes that you must follow to qualify for deferred capital gains tax treatment. The biggest advantage of a 1031 exchange is that the money you would pay in taxes is reinvested in a new property.
Below are seven things to understand before deciding if this powerful wealth building option is right for you.
Make It An Investment, Not Personal
A 1031 exchange is for business and investment properties only, not personal real estate. You can’t use your primary residence in a 1031 exchange.
Properties Must Be “Like-Kind”
The tax code says that both the property you sell and the one you purchase must be like-kind. This is much easier than it sounds. If the property you sell is an investment, it will be like-kind to the property you purchase if it is also an investment. Like-kind doesn’t have anything to do with the quality, location or use of the two properties. For example, an investor can exchange a house for a piece of land, or an apartment building in Miami for an office building in Seattle.
Most Exchanges are “Delayed”
There are several types of 1031 exchanges, all of which do the same thing—swap one property for another. The delayed, or forward exchange is by far the most common. In a delayed exchange, you are given time (i.e., a delay) between selling a property and having to purchase a replacement property. Unfortunately, it’s probably not as much time as you’d like.
You Don’t Have A Lot Of Time (Actually Very Little)
The IRS has strict time limits on how long you can “delay,” and unlike your tax returns, they don’t allow extensions. So if you violate either of the following time limits, you’ll owe taxes.
The 45 Day Rule: This rule says that you have 45 days from the date you sell your property to identify potential properties you may purchase. As a general rule, you can identify up to three potential properties, as long as you end up buying at least one of the three. It is possible to both identify and purchase more than three properties, but for most real estate investors one or two is plenty.
The 180 Day Rule: This rule gives you 180 days from the date you sell your property to purchase at least one of the properties identified under the 45 Day Rule.
It important to recognize that the 45 Day Rule and the 180 Day Rule run concurrently, both starting on the day you sell your property.
You Need A Qualified Intermediary
The IRS does not allow you to touch or use the proceeds from the property you sell, except to purchase another property. For example, if sales proceeds are deposited in your checking account, that sale no longer qualifies for an exchange. The tax code requires those doing a 1031 exchange to use a “qualified intermediary” or QI. A qualified intermediary holds your money in escrow until you are ready to purchase another property. The QI also assists in putting together the paperwork required to report the exchange on your taxes.
Buy A Property That Costs As Much As the One You Sold
To defer all of the taxes on a sale of your property, remember two things:
Reinvest All the Cash: Any cash you receive from the sale of your property will be taxable. For example, if after selling a property and repaying the mortgage/closing costs you are left with $100, you have to reinvest the entire $100 on the purchase of the next property. If you spend less that $100, you will owe taxes on the difference.
Same Size or Bigger Mortgage: The amount of the mortgage on the property you purchase needs to be equal or greater than the mortgage on the property you sell. For example, if the mortgage balance at the time you sell your property is $50, make sure the mortgage on the property you purchase is, at least, $50. If the mortgage on your new property is less than $50, you will owe taxes on the difference.
Taxes Are Deferred, Not Eliminated
Again, the biggest advantage of a 1031 exchange is that the money you would have to pay in taxes gets reinvested in a new property. However, when property purchased through an exchange is sold; you will owe the taxes—unless you do another 1031 exchange. This is how many real estate investors continue to grow their real estate wealth over periods of time.
1031 exchange investing doesn't have to be difficult. That’s why we’ve created an investor guide that tackles the art and science of completing an exchange, and the pitfalls to avoid. What is a 1031 Exchange? features helpful charts, diagrams, timelines, and more. Get your copy today.