For many people, when they leave their job, they often bring their 401(k) with them. The 401(k) provides tax deferment benefits. In order to move their 401k out of the company, it needs to be rolled over into an IRA. This will allow the 401(k) tax deferment benefits to remain in place.
There are rules around the timeline and how the money is exchanged for completing the rollover. But overall, if someone follows the process correctly, they can avoid a taxable event. There’s a similar concept in real estate investing.
Real Estate Tax Deferment
The 1031 exchange allows real estate investors to sell a property and roll the proceeds over into like-kind property. By utilizing a 1031 exchange, any gains from the sale are tax-deferred.
By deferring taxes on the sale of the relinquished property, investors have more gains to put towards a replacement property. There are rules on how gains are used when purchasing the replacement property, along with deadlines that investors must adhere to.
1031 Exchange Rules
To successfully execute a 1031 exchange, investors must abide by property identification rules and specific deadlines.
Property Identifications Rules
There are three ways to identify a replacement or like-kind property:
1.) Three property rule — you can identify up to three properties. You can also acquire up to three properties.
2.) 200% rule — if you want to acquire more than three properties, consider this rule. It allows you to identify more than three properties as long as their total value doesn’t exceed 200% of the relinquished property’s value. It’s a good idea to leave a little padding such as 180% or 190% of the value.
3.) 95% rule — if you need the highest level of flexibility in identifying properties, the 95% rule is probably what you’re looking for. It has no restrictions on the number of identified properties or dependencies on the relinquished property value. However, this is probably the most difficult rule to execute in practice.
To execute this rule successfully, you must close on 95% of all identified properties' value. If the value closed is less than 95%, the 1031 exchange may be invalidated, creating a taxable event in the process.
Another critical part of a successful 1031 exchange is following the deadlines.
1.) 45-day rule — once the relinquished property is sold, you have 45 days to identify a replacement property. It’s best to start looking for potential replacement properties before beginning a 1031 exchange because of the short timeline.
2.) 180-day rule — the entire exchange (close to close) must be completed in 180 days, including the 45-day identification period.
One more component to the 1031 exchange is the use of a QI or qualified intermediary. They facilitate the entire process.
When your relinquished property is sold, you aren’t allowed to come into contact with the proceeds. That money should instead go into an escrow account. The person who facilitates that process is the QI.
The QI collects funds from the sale of the relinquished property and uses them to buy the replacement property. They also set up the escrow account to hold funds until the replacement property is purchased.
The QI industry is unregulated. This means it will be well worth spending time to find a reliable QI with experience in successfully facilitating 1031 exchanges.
It may sound like a lot (and it is) but successfully executing a 1031 exchange isn’t all that difficult. It is important to use a reliable QI and a finance team to ensure everything goes smoothly. If the 1031 exchange is successfully executed, taxes on gains will be deferred until the property is sold.
The 1031 Investor's Guidebook
Tackle the art and science of completing your 1031 exchange.