When taxpayers execute a 1031 exchange, they must adhere to the rules, including the timing deadlines. In brief, a 1031 exchange allows you to defer payment of capital gains taxes when you sell an investment property if you replace it with a "like-kind" property of the same or greater value. If you think about it, that enables you to leverage your gain to reinvest the entire proceeds from a sale rather than diverting a portion of it to pay taxes. As a result, this tool becomes a valuable part of their investment strategy for many investors.
How does a 1031 exchange work?
Under ordinary circumstances, you will owe taxes on the capital gain if you sell an investment property. That gain is the difference between the sales price and the adjusted basis. Typically, if you own an asset for less than one year, you will owe taxes at the ordinary income rate, which is as high as 37 percent (rates change from time to time). However, if you hold the property for more than one year, the tax is calculated at the long-term capital gains rate, which is almost always lower and currently between zero and twenty percent.
Let's look at an illustration. Suppose you want to sell property that you have owned for three years, and your adjusted basis (purchase price plus improvements and acquisition costs, minus depreciation claimed) is $400,000. If you sell the asset for $500,000, your gain is $100,000, and you might owe as much as $20,000 in capital gains taxes, leaving you with $80,000 to reinvest in another property. However, if you perform a 1031 exchange to complete the transaction, you can leverage the entire $100,000 to buy your next property.
One of the remarkable advantages of 1031 exchanges is that they can be performed sequentially. That means an investor can accumulate the capital gains tax deferrals each time they engage in a 1031 exchange. Taking the above example to the next stage, the investor can later sell the replacement property and conduct another deal, again leveraging the entire proceeds rather than paying the capital gains taxes. It's important to note that this process does not eliminate the taxes. They are simply deferred.
However, if the investor continues deferring until they bequeath the final property to an heir, they will successfully erase the taxes. That result is because the heir receives the property on a stepped-up (current value) basis and will not owe taxes on any appreciation or accumulated deferrals before the previous owner dies.
Don’t miss the deadlines.
Initially, investors completed simultaneous 1031 exchanges in which the parties involved would trade property, or the sale of the relinquished asset would take place at the same time as the purchase of the replacements. This scenario is rarely feasible today, so the IRS governs the process with deadlines for investors to follow. The first applicable deadline is the 45-day identification milestone. Once the first property sale closes, the investor has 45 calendar days to identify potential replacements.
Identification is a formal process; the potential acquisitions must be reported to the Qualified Intermediary, a neutral administrator managing the 1031 transaction. The new asset or assets must replace the entire value and debt of the original investment. The investor has several options for replacing the property, including buying one new property, several, or investing in a DST (Delaware Statutory Trust). Investors can also use a combination of direct property acquisition and DST investments.
Inclusive of that 45-day deadline, the entire exchange must be completed within 180 days of the closing on the relinquished property. Again, using a professional Qualified Intermediary is essential to success. That person (or company) receives the replacement property identifications, holds the funds in escrow between the sale and the subsequent purchase, and manages all the documentation for the tax filing.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.
Hypothetical examples shown are for illustrative purposes only.