A 1031 Exchange is a term used to discuss the A “1031 exchange” is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section discusses the process of exchanging one investment property for another by way of a 1031 exchange. By doing this, an individual investor may be able to defer capital gains (or losses) that they would otherwise have to pay at time of the sale.
WHY A 1031 EXCHANGE?
It gives real estate investors an opportunity to defer paying capital gains in order to continue building wealth through real estate investing.
Example:
You buy a piece of real estate for $200,000 and then sell it for $300,000. You are responsible for paying capital gains on the $100,000 profit. You would lose between 25%-30% depending on your tax bracket.
With a 1031 Exchange, you might be able to use the $300,000 to buy one or more new properties and pay no capital gains now. The sale’s proceeds can fund a new investment that could generate cash flow and appreciate.
You will eventually have to pay taxes when you sell these new properties. But this is a process that many successful investors use to increase their holdings – buying bigger and better properties over time to increase wealth.
TYPES OF PROPERTIES THAT QUALIFY
So what qualifies for a 1031 exchange? The simple answer is that it depends. The IRS code says that the properties must be “like-kind” but that answer is somewhat vague.
“Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
It is important to get professional help if you are considering a 1031 Exchange. I have personally used the company 1031 Corp in the past. They do a great job of guiding you through the process and answering questions to determine if this is the right solution for you.
RESTRICTIONS ON 1031 EXCHANGES
There are some additional restrictions to doing a 1031 Exchange. This list is not comprehensive and you should consult with a tax professional to discuss your specific investments.
- It needs to be a “like-kind” exchange
- You need to own it personally (not shares in a REIT, a fund or LLC that owns another LLC)
- You cannot sell an investment property and perform a 1031 exchange into a personal residence
- If you sell a property and exchange it for a cheaper property, you’ll have to pay the capital gains tax for the difference
IMPORTANT TIMELINES
- 45 Days – you have 45 days from the date that you sell the “relinquished” property to identify a “replacement” property/properties. This has to be done in writing, signed by you and delivered to a qualified intermediary (I’ve used 1031 Corp successfully in the past). The qualified intermediary will hold the funds until you buy the replacement property/properties. That way, the funds are never in your possession. They will also file the appropriate IRS forms.
- 180 days – You then have 180 days to settle on one/all of the identified properties.