What Is a 1031 Exchange and How It Works?
If you own investment property then you might know a little bit about a 1031 exchange. This is a portion of the tax code that helps investors in real estate defer taxes on their property and making it so you don’t have to immediately pay a hefty capital gains tax.
This occurs when you invest the proceeds into a new property, making it an exchange instead of a sale. This is one way the tax code can be used to an investor’s advantage to help build wealth and help the economy.
However, there are some regulations and rules regarding this, and you should definitely consult with a real estate investment firm before attempting a 1031 exchange. There are simply too many rules that can go wrong. Below is a list of factor to consider when setting up a 1031 exchange.
Setting Up a 1031 Exchange
- The homes have to be investments. Regular homeowners that live in the home they plan to sell (or buy) can’t take advantage of this. Both homes in the transaction must be investments. However, some personal property can qualify, such as fine art. Tenant in common does also qualify.
- The new investment property has to be worth more than the one you are selling, or of equal value. You need to be trading up, basically. If you pay less for the new property you’ll pay taxes on the difference.
- Some previous loopholes have been tightened. It is possible to do a 1031 on your vacation home, however you will need to have a tenant for at least six months to a year to convert it to investment property.
- If you wanted to use the property you acquired in the exchange as your primary dwelling, you can’t live there immediately. There is a rule that says in each of the two years after the exchange you must have renters in the dwelling for 14 days or longer and your own use cannot exceed 14 days.
- If you decided to do a 1031 exchange after the first sale of property the funds are held in escrow. This is an account that is independent and monitored by someone else, a third party. Once you close on the new property you can access the funds.
- Closing can be unpredictable, so you can choose multiple properties. You are allowed to pick three and then you close on at least one of them.
- The fair market value can’t be more than 200% of the original property.
- If you choose to not follow the 200% rule, you can buy any amount of replacement properties for 95% of the value. An example would be property one being sold for $500k, and then you find several properties for $2.5mil. You must actually buy $2.375mil (95%) worth of those properties.
There are certainly pros to a 1031 exchange. There are many reasons people choose to invest in commercial properties, and completing a 1031 exchange transaction can be a perfect fit. Not having to pay a large capital gains tax immediately will certainly help you as the taxpayer. Here are some pros to consider.
- You’re deferring taxes, and those taxes can be a large amount.
- You’ll have more finances available for investment.
- Instead of just one property, you could acquire another one or potentially several.
- You could also get relief from managing a property. If you have a burden of a large amount of maintenance costs you can trade for something less labor intensive maybe with an onsite manager.
- It is a great way to build wealth if used as a tool to do so. This adds to your available funds. There is the potential to exchange into number ours properties over the years and then pass on to your children. This can eliminate the tax burden completely in the event of your passing.
There are also cons to a 1031 exchange. A few things to consider if you will be attempting to do this with a professional.
- There are a lot of rules to follow. Not adhering to them could cause you to incur tax penalties. Investors can hit roadblocks when trying to comply. The most common issue is when you can’t find a second property in the 45 days allotted after the sale of the relinquished property. Unfortunately, the IRS doesn’t give extensions, either. If an investor ever sells their replacement property the deferred gain will be taxed under the rules as well. An increase in tax rates could be a problem.
- Losses aren’t recognized. Taxes are deferred but then so are losses and this can be a difficult decision to make. Keep in mind this is a tax deferral, not tax free purchase!
4 Necessary Steps
There are a number of steps that are typical of a 1031 exchange. Although you must hire a professional to complete the 1031 exchange, you should be fully knowledgeable about the process. Below are some of the steps necessary to complete the transaction.
- You’ll need the services of a professional such as tax counsel or an accountant (CPA).
- Sell the property with a clause in the Cooperation Clause in the agreement.
- Set up and enter into a 1031 agreement. This must meet tax law, of which there are many requirements.
- The closing of the relinquished property escrow is now the first day of the exchange time limit of 45 days. Written identification of the new property must be sent within the 45 day time limit, and the property must be obtained by the taxpayer in 180 days.
- The buyer then must send a written identification of the address and legal description of the replacement property before the time limit of day 45.
- Taxpayer enters agreement to buy the property, again including the cooperation clause.
- Close before day 180.
- Taxpayer files form 8824 with IRS when they file taxes.
Doing a 1031 exchange should be done with the guidance of a real estate investment firm, not on your own. There are just too many rules and regulations and things that could go wrong doing it by yourself.
Benefiting from a 1031 exchange is one way the tax code helps investors and makes it so that an average person can grow financially with real estate investing. If you are considering doing an exchange, you will definitely need to do your research.