The 1031 exchange can be an effective tax-advantaged tool for selling investment real estate, buying more, and potentially deferring taxes on capital gains and depreciation recapture. But there is more than one way to execute—and complete—a like-kind exchange.
Knowing the different types of exchanges available could help you find the best options for your investment and tax strategies. Below is a list of the various types of exchanges with a brief description.
Also known as a “forward” exchange, the delayed 1031 exchange is widely regarded as the most common. Through this process, you sell your relinquished property and identify a replacement property within 45 days of that sale. You then close on the replacement property within 180 days of the sale of your relinquished property.
The reverse exchange strategy involves acquiring a replacement property before divesting your relinquished real estate asset. In this case, you would buy the replacement property immediately and put the title in the hands of an Exchange Accommodation Titleholder (EAT). You have 180 days from closing the replacement property to sell the relinquished one.
This method requires closing the sale of the relinquished and replacement properties on the same day. At one time, the IRS only allowed this type of exchange. However, this process carries a higher execution risk, which means it’s rarely used.
An improvement exchange (or construction exchange) lets you use exchange funds for capital improvements on a replacement property. However, those upgrades must be completed within the 180-day-to-close window to avoid triggering taxes. You receive the property from your EAT when renovations have been completed.
With this exchange type, you use partial proceeds from the relinquished property sale to purchase the replacement property. The remainder comes to you in cash. The funds channeled into the replacement property can defer capital gains and depreciation recapture taxes. However, the other proceeds are considered “boot” and subject to taxes.
The exchange type you use depends on your comfort level and real estate investment strategy. Each offers advantages and disadvantages, which you should look into closely. Be sure to partner with an experienced Qualified Intermediary and tax professional to understand the rules involved with each exchange type, and to ensure the process helps you achieve your financial goals.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.