1031 exchanges have been used by savvy real estate investors for decades. When done properly, a 1031 exchange allows you to legally defer paying taxes on investment gains when you sell qualified property and buy a replacement. What does this rule mean for investors? let's dive in!
In this Guide:
- What is a 1031 exchange?
- What is the IRC Section 1031 exchange rule?
- Qualified Brokers and Implementation of 1031 Exchanges
- Properties must be “of the same type” to qualify
- timing is everything
- Types of 1031 exchanges
- How depreciation works in a 1031 exchange
- Property types that match… and don't match
- Your earnings are tax-deferred, not tax-deferred
- Some words of caution
- A stress-free way to do a 1031 exchange
What is The 1031 Exchange?
The premise of this rule is simple. When you sell an investment property, you generally have to pay taxes on the gain at the time of sale. Section 1031 of the Internal Revenue Code (IRC) provides an exception. You can defer paying taxes if you switch to “like-kind” investments.
The main difference is that you are exchanging rather than selling investments. It's pretty easy to figure out, but there are strict IRS rules you must follow to make it work.
There is a lot of misinformation out there. I hope to clarify some of them in this article.
What Is the IRC Section 1031 Exchange Rule?
1031 Exchange Rule A 1031 exchange gives real estate investors a key benefit offered by a traditional IRA or 401(k) investment plan: tax deferral. A transaction within your pension plan, such as the sale of fund shares, is not a taxable event. Capital gains tax is deferred. You still keep the money in your plan account.
The same principle applies to tax-deferred exchanges of real estate. As long as you keep the money invested in similar properties (and follow all the rules), your capital gains tax can be deferred.
What's the Concept?
The concept is that the taxpayer simply exchanges one investment property for another “of like kind”. The taxpayer did not receive anything for paying the tax. All income is still locked up in the new property, so no income is “recognised” for income tax purposes.
In a qualified retirement plan, you pay no taxes until you withdraw the funds. With a 1031 exchange, you don't pay any taxes until you sell the property being replaced. And you can later do another 1031 exchange on the same property and defer the tax again.
Section 1031 and Sale of Real State Property
Section 1031 is most commonly used in connection with real estate sales. But some exchanges of personal property also qualify under Section 1031.
Consult an expert as exemptions have been added in 2018. Types of property now specifically excluded from Section 1031 include business interests and assets such as inventory, machinery, equipment, vehicles, and intangible business assets such as intellectual property.
Qualified Intermediaries and Executing a 1031 Exchange
Qualified Intermediary All Section 1031 financial transactions must go through a qualified intermediary (QI).
The broker keeps the proceeds from the sale and then releases the money at the closing of the traded property. To qualify, the cash from the original sale must be reinvested to purchase the new property. Any cash retained by the taxpayer/seller from the sale of the old property is taxable gain.
A broker is considered qualified by the IRS because they are an independent party for the sole purpose of facilitating the exchange process. You may not act as your own broker. Your agent also cannot act as your intermediary. (“Agent” includes your real estate agent, investment banker, accountant, attorney, or anyone else who has worked for you in one of these capacities in the previous two years.)
A 1031 exchange usually works like this. At the closing of the sale of the relinquished property, the proceeds go directly to QI. QI holds the funds until the transaction to purchase the replacement property is ready to close. QI then sends the proceeds of the sale to purchase the replacement property. Upon completion of the acquisition of the replacement property, the QI delivers the property to the taxpayer. All of this income is without the taxpayer having what the IRS calls a “constructive receipt” of the funds.
The Properties Must Be “Like-Kind” to Qualify
IRC Section 1031 allows you to defer income tax only if you reinvest the income in similar or the same type of property. Of the same kind means the same in nature, character, or type. Quality or grade does not matter.
Most real estate will look like other real estate. But there are exceptions. For example, real estate in the United States is not the same type of property as property outside the United States.
There are other rules regarding “same type”. For example, property intended for personal use does not qualify. This includes your primary residence, second home and holiday home. (See below for what qualifies as a vacation home.)
To make sure you're doing it right, refer to all the expert rules.
Timing Is Everything
Timing is everything. A similar exchange need not be a simultaneous exchange of properties. But you have to complete two terms or the entire profit will be taxed. These deadlines cannot be extended under anycircumstances (except in cases of presidentially declared disasters).
First, you have 45 days from the date you sell the relinquished property to identify a potential replacement property. This is known as the identification period. The identification must be in writing, signed by you and given to your QI or property seller. Notifying someone acting on your behalf in any part of the transaction is not sufficient.
During this identification period, you have three options to find your replacement property. You can also:
- Identify up to three properties as potential purchases; or
- Identify any number of replacement properties as long as their total value doesn't exceed 200% of the value of the property being sold; or
- Identify as many properties as you like as long as you acquire properties valued at 95% or more of their total.
No matter how many properties you identify, you must clearly describe those replacement properties with a mailing address or legal description.
The second period is the exchange period. The exchange property must be received and the exchange completed no later than 180 days after the sale of the exchanged property.
Thus, to successfully complete a 1031 exchange, a taxpayer must identify a replacement property within 45 days of the sale of the original property and purchase the replacement property within 180 days of that closing. This ensures investment continuity as required by the IRS.
Types of 1031 Exchanges
- Simultaneous Exchange A simultaneous exchange is the exchange of a relinquished property with a replacement property that occurs at the same time. This is rare simply because it is nearly impossible for everything to happen at the same time when dealing with two separate transactions as complex as real estate transfers.
- Deferred Exchange — In the most common deferred exchange (also known as a forward exchange), the disposition of the relinquished property and the acquisition of the replacement property are interdependent parts of an integrated transaction that facilitates the exchange of property.
A reverse exchange is when the investor acquires the replacement property before transferring the surrendered property.
- Construction Exchange — A building exchange is when the taxpayer uses a portion of the proceeds from the sale of the relinquished property to improve the replacement property. Construction must be completed before the usual 180 day limit. This time limit makes this type of 1031 exchange difficult for most investors.
How Depreciation Works With a 1031 Exchange
The depreciation tax credit allows real estate investors to offset the value of the property over a predetermined life. In a 1031 exchange, you replace that property with new property. If the replacement property has the same value, continue the depreciation calculations as if you still owned the old property.
If the replacement property has a higher value, you treat the additional amount as you would the construction cost of the old property (as an appreciation allowance). The depreciation method you use is most appropriate for the type of property being replaced.
Types of Properties that Qualify… And Don't Qualify
To qualify as a Section 1031 exchange, a deferred exchange is different from when the taxpayer simply sells the property and uses the proceeds to purchase other property (which is a taxable transaction).
Both the relinquished property you sell and the replacement property you buy should be treated as investments. This means they generate income, such as a rental property, or are expected to increase in value, such as vacant land, which you intend to sell later for a profit.
Property used primarily for personal use does not qualify for a like-for-like exchange. This means your primary residence or second home does not qualify.
A vacation property may qualify for a 1031 exchange under several circumstances.
- You rent the home at fair market value (FMV) for at least 14 days per year, and
- You, your friends and family use the home for no more than 14 days per year or 10% of the FMV rental days, whichever is greater. (“Friends and relatives” in this case means people who don't pay FMV. If they do pay FMV, those rental days are included in #1 above).
There are other restrictions. So before you assume your vacation rental qualifies, check with an expert.
Taxpayers who buy real estate for resale (flippers) are considered “dealers” and cannot use Section 1031 to defer tax, even if they accumulate profits from their subsequent investments.
Your Gain Is Tax-Deferred, Not Tax-Free
As mentioned above and very important to remember. when you use a 1031 exchange, you defer tax because you are exchanging one like-kind asset for another. It helps your current cash flow, but your profit will eventually be taxed when you sell the new property.
There is a silver lining, there is no time limit on holding the property. You can defer taxes as long as you continue to own the property. And you can do another 1031 exchange on the same property in the future and defer the tax again as long as you exchange the same type of property and follow all the rules.
You won't even have to sell the property in your lifetime. Then you can pass it on to your heirs
A Few Words of Warning
The IRS warns that you should be wary of people who facilitate the abuse of similar exchanges. Some educational materials and Internet sales publications suggest that a vacation home automatically qualifies for a 1031 exchange.
Promoters of notional exchanges often refer to them as “tax-free” exchanges rather than “tax-deferred” exchanges. And they may even advise you to request an exchange even though you have already taken possession of the cash from the property sale.
Don't fall for the misinformation about doing a 1031 exchange. Find an experienced QI before doing anything.
And it is very important to remember that not following the deadlines and all the rules will result in unsuccessful trading. For example, if you control the cash or other income before the exchange is completed, the entire transaction in the same type of exchange treatment is disqualified and all gains are immediately taxable. You may even be responsible for penalties and interest on your transactions.
I highly recommend that you hire a professional when doing an IRC Section 1031 exchange.
A Stress-free Way to Do a 1031 Exchange
Online real estate platforms have revolutionized the way investors purchase real estate. Many of these platforms allow you to buy commercial and residential real estate shares with relatively small minimum investments required.
But what you may not know is that some of these platforms allow you to defer your capital gains tax when trading investments thanks to the 1031 exchange.
Here's a list of real estate platforms we've reviewed that offer this feature:
|Account Fees||1-1.25%/year asset management fee||None|