A 1031 Exchange is section of the IRS tax code that allows investors to defer the payment of capital gain taxes and depreciation recapture taxes by reinvesting the entire proceeds of the sale into the purchase of a qualifying replacement property or properties. In this article, we will focus on the various types of 1031 exchanges and how they can help you defer taxes.
What are the Types of 1031 Exchanges?
There are four major kinds of 1031 Exchange available to you. They include:
1. Simultaneous 1031 Exchange
This is the oldest and less patronized form of doing a 1031 exchange. Also referred to as Forward 1031 exchange, it requires that you sell your relinquished property and immediately purchase a replacement property. In this type of exchange, the closing of the sale of the relinquished property and replacement property occur on the same day, usually simultaneously.
2. Delayed 1031 Exchange
This is most preferred method of doing a 1031 exchange by real estate investors. This type of exchange allows you to close on the sale of your relinquished property before closing on the purchase of your replacement property at a later date usually within 180 days. In the delayed exchange, you need the service of a qualified intermediary to handle the exchange on your behalf.
More importantly, there are strict timelines associated with the delayed exchange. For instance, you must identify a replacement property or properties within 45 days of closing on your relinquished property and must also close on the purchase of your replacement property within 180 days from sale of your old property. Delayed exchange are protected by the Safe Harbor Regulation.
3. Reverse 1031 Exchange
If you’re familiar with the US real estate market, then you will realize that it is more of a seller market than a buyer market. Sometimes there is a rise and fall in the price of homes, which makes buying a property a huge challenge. Therefore, a reverse exchange is an excellent strategy when dealing with a hot market with limited inventories.
A reverse exchange simply means that you purchase your replacement properties first before selling your old property at a later date. In this type of exchange, the qualified intermediary holds title to your acquired replacement property pending when you are able to sell your relinquished property.
During the closing period of the sale of your relinquished property, the QI transfers the title to the replacement property to you. Just like the delayed exchange, you have 180 days to sell your relinquished property upon the purchase of your replacement property.
4. Improvement/Construction Exchange
While this type of 1031 exchange is structured like the reverse exchange, the construction or improvement exchange allows you to sell your relinquished property and use part of the realized exchange dollars to make capital improvements to the replacement property. For example, you sell your relinquished property for $400,000, then purchase a replacement for $300,000 but require $100,000 worth of capital improvement.
In a situation like this, your qualified intermediary or Exchange Company takes title to the replacement property while you do the improvement to the property. Then upon the completion of the improvements by 180 days, your QI will have to transfer the title to the replacement property to you.
This is a great strategy if you want to build a custom home while qualifying for 1031 exchange. However, you should take into considerate the limited time-frame before doing an improvement 1031 exchange.
Learn more about 1031 Exchanges and Delaware Statutory Trusts as replacement properties.