1031 Exchanges for Dummies
Carl E. Sera, CMT
September 25, 2020
Doing 1031 Exchange the Right Way
There are numerous benefits associated with investing in a real estate investment property. They range from diversification to equity building to potential cash flow to tax advantages. However, selling a real estate property or rental property comes with up to 4 taxes which consumes a substantial part of your profit. When you sell, the tax collector becomes your partner. It’s a dirty little secret that most real estate investors don’t understand when they start their real estate journey. But there is a solution, it’s called a 1031 exchange.
What is a 1031 Exchange?
At the basic level, a 1031 exchange is a construct of the IRS 1031 tax code that allows an investor to sell one property and transition to another while deferring the payment of capital gain taxes indefinitely. A 1031 exchange is a very useful tool because it allows you to reinvest the full value of your proceeds and not have to pay taxes on the gains. Furthermore, the investor can exchange as often as they like to as many properties as they like.
1031 Exchange Requirements
- You Must Use A Qualified Intermediary or QI
A qualified intermediary is not your broker or even your attorney but a third-party individual who is versed in 1031 exchange processes. This individual or company will help you fill out the paperwork, they’ll go through all the nuances of your specific situation, and make sure everything is done correctly. Make sure you have hired a QI before you close on the sale of your relinquished property or with rare exception, it will be too late to take advantage of the 1031 exchange. You can call us for a list of top 1031 Qualified Intermediaries.
- Your Exchange Properties Must Qualify as A Like-Kind Property
The property you are selling as well as the property you are buying must both qualify as a like-kind. That is, they must be held for trade, business, or investment purposes. You could sell an apartment building and purchase a net-lease property. You could sell an industrial property and go on to buy a retail strip center.
What you can’t do is sell an investment property and then reinvest into something that you will be living in such as a primary residence or vacation home. You also cannot exchange into something that you already own or something that a relative or family member owns.
- You Must Identify the Replacement Property Within 45 Days
This is where many investors doing a 1031 exchange get into trouble with the IRS. The identification period is 45 days from the day that you close on the sale of your relinquished property. Remember that the 45 days identification timeline is included in the total 180 days’ timeline. You will need to identify the replacement properties in writing with your QI, which is just one of the services they provide.
In identifying your replacement properties, you’ll need to choose from three IRS-stipulated identification rules to help you do it the right way.
- Three-property Rule: This is the most common of the rules. Under the three-property rule, you can identify three properties of any dollar value and close on one or two or even three of the identified properties.
- 200% Rule: Under the 200% rule, you can identify any number of properties but they cannot exceed the 200% of the value of your relinquished property. If you are looking at an all-cash exchange, then this could be a good option.
- 95% Rule: This is the least common and under the 95% rule, you can identify any number of properties for any dollar value but you must close on 95% of everything that you identify.
- You Must Close on the Sale of the Replacement Property Within 180 days
Upon the sale of your relinquished property and identification of your replacement properties, you must close on the purchase of your replacement property within 180 days. Remember that the 45 days identification is a part of the 180 days, so in reality, you have 135 days to close on the new property purchase.
- Reinvest Equal or Greater Amount
Before your exchange can qualify for capital gain tax deference, you must reinvest an equal amount or greater amount in the purchase of your replacement property. For instance, if you sold your relinquished property for $300k, you must purchase a replacement property with a value of $300k or higher to qualify. It’s even a bit more complicated because you must also meet or exceed the same level of debt and equity as on your relinquished property.
What does Tax-Deferral Mean?
When most new real estate investors looking to do a 1031 exchange hear about tax deferral, the first thing that comes to their mind is permanent avoidance. The short answer is that you will still need to pay capital gains taxes to the IRS in the future unless you perpetually defer and then upon death your heirs receive a stepped-up cost basis. This is why coordinating your real estate exit strategy with estate or legacy planning is critical.
While doing a 1031 exchange is an excellent tool to defer the payment of taxes in the present, always remember, it is not a tax-free strategy. It only helps you defer these payments to a future date unless you keep doing 1031 exchanges till death.
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