Real estate investors often swap one property for another through 1031 exchanges. By completing exchanges, investors avoid generating a taxable event from the sale of their original properties.
Since investors are rolling over sale proceeds instead of cashing out their profits, the Internal Revenue Service allows exchangers to defer any capital gains incurred from the sale of their relinquished assets. There are some very strict rules and deadlines that have to be met in order to ensure a successful 1031 exchange. This article takes a deeper look into these important rules and also provides an example of a hypothetical exchange to help investors better understand how the process works and potential tax savings.
1031 Exchange Rules and Deadlines
A 1031 exchange occurs when real estate investors sell one investment property (the relinquished asset) and roll the proceeds over into a “like-kind” property (the replacement asset). By completing exchanges, investors can defer any capital gains liabilities on their profits. If you plan on selling an investment property and completing a 1031 exchange, you’ll have to file a Form 8824 in the year the exchange occurred.
There’s no limit on the number of times you can roll over sale proceeds from a relinquished asset into a replacement asset. Theoretically, you can continue swapping investment properties until you pass, whereupon your beneficiaries will receive a one-time step-up in basis that could effectively negate any accumulated capital gains tax liabilities on your investments.
- Identify a like-kind asset within 45 days. You must target a replacement asset within 45 days from the close of sale on your relinquished property. You can identify as many as three properties depending on asset value. Under the 200-percent rule, you can identify unlimited properties provided their net value remains under 200 percent of your relinquished asset. Lastly, the 95-percent rule stipulates that you can identify more than three properties with a net value greater than 200 percent of your relinquished asset provided you acquire 95 percent of the net value of those assets.
- 180 days to close. Once you have replacement assets identified, you must close on them within 180 days from the close of the sale.
- Use of a Qualified Intermediary. This is a tremendously important rule. You must use a Qualified Intermediary (also called a QI or an exchange accommodator) to hold sale proceeds in escrow, acquire your replacement asset, and transfer title after the exchange is completed. Experienced accommodators prepare and execute all the documentation and tax forms necessary to complete your exchange. Oftentimes, it’s good to use a lawyer or accountant as a QI since they can provide important legal counsel -- but don’t use your own attorney or tax professional. Your 1031 exchange QI can’t have any personal relationship with you in the past two years.
Example of a 1031 Exchange
The exchange process is quite complicated and involves many moving parts. The example below is strictly for general reference -- individuals should consult with the appropriate tax and legal professionals to properly determine the full scope and outlook of their own exchanges.
Say you bought a duplex some years back for $1 million and you want to sell it for a profit. You can defer capital gains on those proceeds by completing a 1031 exchange.
Relinquished asset purchase price: $1 million
Capital improvements: $100,000
Adjusted basis: $1,000,000
Sale price: $2 million
Expenses related to sale: $100,000
Net sale price: $1.9 million
Depreciation recapture at 25 percent: $25,000
Capital gains tax at 20 percent: $165,000
Section 1411 Medicare Surtax at 3.8%: $34,200
Total tax liability: $219,200
Net proceeds: $1,900,000
Taxes due: $219,200
Reinvestment capital: $1,680,800
Net proceeds: $1,900,000
Taxes due: $0
Reinvestment capital: $1,900,000
You can see from this example how a tax-deferred exchange can preserve a larger sum of capital for reinvestment.
The Bottom Line
A 1031 exchange is a complicated real estate transaction. There are so many ways even seasoned real estate investors can get tripped up during the process that it’s a good idea to engage professional help for every step of the exchange. A successful 1031 exchange can preserve more of your wealth for investment, while a disqualified exchange can leave you with a hefty tax bill.