The world of real estate is always changing to meet new demands and expectations. Though it may seem complicated at first, the 1031 exchange is a fairly straight forward tax-deferment strategy that is used by some of the most successful estate agents in the world.
In this article, you’ll learn what a 1031 exchange involves, how it works in practical terms, what benefits you can expect from it, and all of the background knowledge you could need to move forward.
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What is a 1031 exchange?
The 1031 exchange is sometimes known as the Starker Exchange or Like-Kind Exchange. For the sake of simplicity, I’ll be referring to it only as the 1031 exchange throughout this article. It gets its name from section 1031 in the IRS code, but luckily to understand its benefits, you don’t need to go through pages of tax code explanations.
In simple terms, the 1031 exchange allows an investor to defer the payment of capital gains taxes on an investment property once sold, providing that another property of similar value is purchased with the profit gained from the sale of the original property. That sentence is a lot to take in all at once, so let’s break it down:
- You are an investor in a property.
- That property sells, and you would ordinarily need to pay capital gains taxes.
- By utilizing the 1031 exchange, you can defer these payments by purchasing a property of similar value.
- This property must be purchased using the profits of the original sale.
Purchasing a property of similar value includes the base price of the home plus any additional loans. So, for instance, if you were to sell a home in California for $750,000 with a $350,000 mortgage, your new property would have to be equal to or higher than $750,000 with $350,000 leverage.
It’s an excellent way for investors to switch up their investment plans without having to bear the brunt of tax punishments. There are a variety of reasons an investor may want to do this. It could be due to economic reasons if you find your current property is more high-maintenance than you would like. It may be down to a change of location. Whatever your reason for switching investments, it can be enormously beneficial to be clued-up on how the 1031 exchange works.
So, how does a 1031 exchange work?
Though there are numerous ways a 1031 exchange may take place, they all can often be separated into four distinct categories. These four are:
- Simultaneous Exchange.
- Delayed Exchange.
- Reverse Exchange.
- Improvement/Construction Exchange.
They all follow different procedures but still fall under the umbrella of the 1031 exchange, meaning they all allow for the deferral of capital gains taxes.
What qualifies as a 1031 exchange?
Which of the four you choose entirely depends on your situation, the property that you’ve sold, and the property you’re looking to purchase.
Let’s break down the categories, so you know which is most likely to apply to you.
Its name may give it away somewhat, but a simultaneous exchange is the closure of two properties on the same day. Put more plainly; the initial property completes its sales process on the same day the new investment property completes a purchase. Think of it as an immediate hand-over.
The rules surrounding simultaneous exchanges are relatively stringent, so if you’re opting for this form of like-kind exchange, you need to make sure the process is airtight. Delays for whatever reason (including simple payment delays) can break the exchange agreement, which then could incur the full tax penalties.
This completely defeats the purpose of performing a 1031 exchange. While it’s impossible to rule out every single problem that could arise during an exchange, it is possible to minimize the risks you take. These are three example strategies you can use to ensure your transaction isn’t compromised unnecessarily:
- Instead of exchange between two parties, use a third party that oversees the transaction, and only allows the sale/purchase to complete simultaneously.
- Complete a classic trade between two parties wherein the deeds are directly swapped.
- Perform a literal simultaneous exchange via a qualified intermediary.
However you choose to complete your simultaneous transaction, just make sure it’s as airtight as it can be. The sale and purchase of property is a complicated process with a mountain of paperwork often attached, so double-checking you’re doing everything properly is never a bad thing. This is where qualified intermediaries can prove hugely beneficial.
A delayed exchange is easily the more popular of the four strategies and with good reason. It takes place when there is a gap between the sale of a property and the purchase of another. This gap does have a time limit on it, of course, but in terms of flexibility, it’s truly a winner.
It’s easier to implement than other strategies because, as an investor, you don’t need to have acquired a replacement property immediately for the property you previously sold. You’re responsible for marking the original property for sale and securing a purchaser. Still, you do not need to have identified a replacement property as soon as the first property sells.
The grace period for this is 180 days, wherein a third-party intermediary will hold the assets secured from the sale of your original property. The first 45 days of this grace period are for you to find a replacement property. The remaining days after are for the purchase to reach completion. If you don’t adhere to these time frames, the exchange can be nullified, and you will face full taxation.
It’s easy to understand why this form of 1031 exchange is so popular. The extended grace period makes the selling and purchasing of property far less stressful, while an investor still benefits from deferred capital gains taxes. If you do opt for this exchange, just make sure you take the grace period seriously, or you may find yourself with no tax benefits whatsoever.
An easy way to think of the reverse exchange is by considering it the opposite of the delayed exchange. With a reverse exchange, you find a replacement property to invest in before you sell your current investment property. It can be a little tricky, but when done correctly, the reverse exchange can hold a lot of benefits.
Similar to the delayed exchange, the grace period for selling your current property is 180 days. The first 45 days require you to identify which property is going to be sold, with the remaining 135 days used to both complete the original sale and the purchase of a replacement property. Only then is the exchange complete.
Again, just as with a delayed exchange, if this time frame followed then, you miss out on the benefits of the trade, and you will be taxed accordingly. Make sure if you opt for a reverse exchange that your plans abide by the 180 days.
It’s also essential to bear in mind that with a reverse exchange, the entire transaction must be paid in cash, and banks are highly reluctant to offer loans on reverse exchanges.
This makes them somewhat less popular than other 1031 exchange strategies, but they certainly have their benefits. The rules surrounding ‘like-kind’ exchanges are less stringent with this exchange, which can be a massive plus to some.
This form of 1031 exchange differs from the others as it is focused more on the renovation of your new investment as opposed to the sole purchase of the property. Essentially what this exchange allows you to do is make home improvements on your new investment property following the sale of your original investment, provided all upgrades are made with the equity released from the original property.
The 180 day grace period also applies here, as all renovations or improvements must be completed on the new property by the 180th day. The new investment property must also be equal to or exceed the value of the original property. Otherwise, the tax deferrals are considered null.
This exchange allows investors to improve upon their replacement property before relinquishing the old investment. This is done with the assistance of a third party intermediary who will take hold of the property before the 180 day period is up. Using tax-deferred dollars to improve the new investment property has many clear benefits, as it often leads to heightened value.
It’s a method that’s particularly popular among investors that are looking to expand their real estate foothold as opposed to banking the tax deferral.
What are the benefits of a 1031 exchange?
Immediately, the first answer that springs to mind when considering what benefits arise from a 1031 exchange is the tax deferral. Capital gains taxes can amount to a lot of money, so it isn’t difficult to understand why so many investors leap at the opportunity to defer them.
But this isn’t the only benefit that can arise from using the 1031 exchange.
Many investors don’t realize how lucrative a like-kind exchange can be outside of tax deferral. Numerous success stories are detailing how investors managed to swap their high-maintenance, low-income investments for much more lucrative properties while still abiding by the rules of a like-kind exchange.
This is often achieved by taking into account several factors, including location, the age of the home, and the present condition of the real estate market. Knowing the rules of the 1031 exchange highlights your options and puts you in the best position to improve your investment income.
Saving on tax is one thing, but 1031 exchange can raise your property investments to a whole new level. Provided, of course, you know what you’re doing.
Let’s get into some of the rules surrounding the 1031 exchange.
Are 1031 exchanges still allowed?
In short: yes, they’re very much still allowed, but there are specific rules that you must stick by if you’re going to benefit from 1031 exchange. I can’t list every possible outcome you may encounter when exchanging investment properties, but I can give you an overview of what you need to stick to.
Some of these I’ve already mentioned above, but a recap of the rules never hurt anyone:
- 180-day window. If you exceed the time granted to you by the 1031 exchange, you will receive none of the benefits. 180 days is generally more than enough to complete your transaction, but if you’re unsure, a third-party intermediary can be hugely helpful.
- Taxpayer name. The name on the title deed selling the property must be the same name on the property purchased. For instance, if you’re exchanging investments as a married couple, one of you must be the name on both deeds. It must be a direct exchange with one name on both title deeds.
- Equal or higher value. The property you buy must possess a value that is equal to or higher than the value of the property sold. Otherwise, the 1031 exchange does not apply. Don’t catch yourself out with this, always check your numbers.
- Business or investment only. You can’t exchange your primary residence for another. The properties exchanged must be for investment or business purposes alone.
- Like-kind. I‘ve used the term like-kind a lot, but it doesn’t just apply to value. It also applies to the type of building exchanged. For instance: you can’t trade a farming plot for an office block. The quality and location of the property may vary, but it must be similar to qualify as like-kind.
This isn’t an exhaustive list of every rule for every situation, but it’s my top five that should give you a strong foundation to begin exploring how 1031 exchange could apply to your circumstance.
How to defer capital gains taxes with a 1031 exchange
If you’re planning on exchanging investments for the first time, it is strongly advised that you seek professional help to assist you. This guide acts as an introduction to the process, but enacting a 1031 exchange is a complicated process. If you aren’t mindful of the smallest details, you may lose out on eligibility.
The key to deferring capital gains taxes with this method is staying up to date on the real estate market and keeping yourself as economically informed as possible. A qualified intermediary can make all the difference when exchanging for the first time. Property investment exchanges can provide incredible benefits if appropriately executed.
As you can see, there are a ton of tax benefits to doing a 1031 exchange, but you have to know what you’re doing and ensure you’re following the right guidelines.
Remember, this is just a high-level overview of a 1031 exchange. If you’re getting serious about acting on one, it might be in your best interest to contact a tax professional before doing so.