A 1031 exchange is a powerful tax deferral tool that allows investors to sell an investment property and reinvest the proceeds into a new property while deferring capital gains tax. Strict rules and deadlines must be followed to qualify for the exchange, so it's essential to work with a qualified intermediary and have a clear understanding of the process before beginning. There are many types of 1031 exchanges, for this article, we will be discussing tax deferred exchanges for real estate investors.

 

As a real estate investor, you may have heard of 1031 exchanges and how they can be used to defer capital gains taxes. But what exactly is a 1031 exchange? And how does it work?

 

In this blog post, we'll answer some of the top questions investors have about 1031 exchanges, so you can get a better understanding of how they work and whether or not they may be right for you.

What is a 1031 exchange?

A 1031 exchange is a tax-deferred exchange of investment or business property. Under the Internal Revenue Code, you can exchange properties and defer paying capital gains taxes as long as you reinvest the proceeds from the sale into a similar property.

 

To qualify for a 1031 exchange, you must adhere to strict IRS guidelines. The two most important requirements are that you must identify potential replacement properties within 45 days of selling your original property, and you must close on the purchase of your replacement property within 180 days of selling your original property. Usually, real estate investors will also acquire a replacement property of equal or greater value.

What are the benefits of a 1031 exchange?

The biggest benefit of a 1031 exchange is that it allows you to defer paying capital gains taxes on the sale of your investment or business property. This can save you a significant amount of money, and 1031 exchange rules allow you to reinvest that money into another rental property.

 

Another benefit of a 1031 exchange is that it gives you the opportunity to upgrade your property. For example, if you own a small office building, you could sell it and use the proceeds to purchase a larger office building. Or, if you own a single family residence that you rent, you could sell it and use the proceeds to purchase a small apartment building that could produce more income.

 

A 1031 exchange is for "like kind property"

Many people ask what that means. The IRS provides guidance on what they consider like kind but, in general, it means that the two properties are similar in nature and function.

 

For example, you could exchange a rental house for a duplex, or an office building for a retail shopping center. You could also exchange land for another piece of land, or farmland for a ranch. In general, income producing property for income producing property.

 

The benefits of a 1031 exchange depend on your individual circumstances, but they can be significant. Be sure to consult with a tax advisor to see if a 1031 exchange makes sense for you.

 

Under the Internal Revenue Code, you can exchange properties and defer paying capital gains tax as long as you reinvest the proceeds from the sale into a similar property.

What is a 1031 exchange and how does it work?

A 1031 exchange is a powerful tax deferral tool that allows investors to sell an investment property (relinquished property) and reinvest the proceeds into a new property while deferring capital gains taxes. Strict rules and deadlines must be followed to qualify for the exchange, so it's essential to work with a qualified intermediary and have a clear understanding of the process before beginning.

Here's a quick overview of how a 1031 exchange works:

1. The investor identifies a property that they want to sell.

2. The investor enters into a contract to sell the property with a qualified Realtor®.

3. The real estate investor identifies three or more replacement properties that they want to purchase that are of equal or greater value.

4. The investor enters into a contract to purchase the replacement real property and closes on those properties within 180 days after the relinquished property is sold.

 

1031 exchange Rules:

Three Property Rule

The investor must identify no more than three properties, regardless of their value. The three property rule is one of the most well-known rules associated with 1031 exchanges. Under this rule, investors are limited to identifying no more than three like kind properties, regardless of their value.

There are two exceptions to the three property rule:

 

1. The 95% Exception: You can identify more than three properties, as long as you purchase 95% or more of the total fair market value of all identified properties.

2. The Unrelated Party Exception: You can identify more than three properties as long as they're not purchased from related parties. A related party is anyone who has a financial relationship with you, such as a family member, business partner, or close friend.

 

If you're thinking about doing a 1031 exchange, it's important to be aware of the three property rule. Straying from the guidelines could expose you to capital gains taxes.

The 45-Day Rule

One of the most important deadlines to be aware of in a 1031 exchange is the 45-day rule. This rule states that, after selling the relinquished property, the investor must identify replacement property within 45 days.

 

The identification of the replacement property must be made in writing and delivered to the qualified intermediary no later than midnight on the 45th day. The written identification must include all of the following:

 

1. A description of each property identified

2. The address or legal description of each property identified

3. The name of each seller of the property identified

The 180-Day Rule

The final deadline to be aware of in a 1031 exchange is the 180-day rule. This rule states that, after selling the relinquished property, the investor must close on their replacement property within 180 days.

 

There are two exceptions to the 180-day rule:

 

1. The extension for completion of construction: If you're exchanging into a property that's being constructed, you have up to 540 days from the date you sell the relinquished property to complete the exchange.

2. The Reverse Exchange: In a reverse exchange, the investor purchases the replacement property before selling the relinquished property. In this case, the investor has up to 365 days from the date they purchase the replacement property to sell the relinquished property.

 

What happens if I don't complete my 1031 exchange within the deadlines?

 

If you don't complete your 1031 exchange within the deadlines, you will be responsible for paying capital gains taxes on the entire amount of your sale.

 

How do I find replacement properties in a 1031 exchange?

Choosing the right real estate agent to find a great replacement property is crucial to your success. You must find an agent who is experienced in 1031 exchanges and who has a good understanding of your investment goals and the requirements of the internal revenue code.

 

The right agent will not only show you properties that are available on the MLS, they will also help you understand rental rates. Show you on market properties that are currently being rented and producing income and help you understand if a certain property will fit your invest,ent goals.

 

1031 exchange 200% Rule

Investors often ask if there are any limits on how much they can spend on replacement property in a 1031 exchange. The answer is yes – there is a limit, known as the 200% rule.

 

The 200% rule states that the fair market value of the identified replacement properties cannot exceed 200% of the fair market value of the relinquished property. So, if you're selling a property for $1,000,000 you can identify replacement properties with a total fair market value of up to $2,000,000.

 

The 95% rule is the exception to the 200% rule:

 

The 95% Exception: You can exceed the 200% limit if you identify more than three properties, and you purchase 95% or more of the total fair market value of all identified properties.

 

If you're thinking about doing a 1031 exchange, it's important to be aware of the 200% rule. Straying from the guidelines could open you to capital gains tax liability.

Do I have to use all of the proceeds from my sale?

No, you are not required to use all of the proceeds from your sale in your 1031 exchange. In fact, you can choose to pocket some of the cash and only reinvest a portion of the proceeds. However, if you do choose to pocket some of the cash, you will be subject to capital gains taxes on the amount that you don't reinvest.

 

For example, let's say that you sell a property for $1,000,000. If you choose to only reinvest $800,000 in your 1031 exchange, you would be responsible for paying capital gains taxes on $200,000.

 

However, there is an exception to this rule known as the "boot". If the "boot" is less than $200,000, you may be able to defer the taxes on the boot by doing a partial 1031 exchange.

 

A partial 1031 exchange is when you reinvest part of the proceeds from your sale in the replacement property, and you pocket the rest. In order to do a partial 1031 exchange, you must still follow all of the other rules and guidelines that apply to a regular 1031 exchange.

How long must I rent the new property? Could I move in?

There is no minimum rental period for the new property, but it is generally recommended that you rent it for at least one to two years before taking up residence. This gives you time to show that it was your intent at the time of the exchange to keep this new property as a real estate investment property. If you decide to move into the property before the one-year mark, you may be subject to capital gains taxes on the sale because you would not have the tax returns to show the income from the like kind property that you purchased.

 

Since there is no clear direction from the internal revenue service, each exchange facilitator will often answer this question differently.

Do I have to buy the identified property or can I replace it with something similar?

You can change your mind as long as you are still within the 45 calendar day identification period. After midnight of the 45th day, you cannot change the identified properties.

 

You can also swap properties with other exchangers as long as you do so within the 45 calendar day identification period.

Can I use funds to pay off existing mortgage?

Yes, you can use the proceeds from your 1031 exchange to pay off an existing mortgage on the property that you are selling.

Can I use funds to pay for commissions and other expenses associated with the sale?

You can use the net proceeds from the sale of your relinquished property to pay for routine selling expenses such as real estate commissions, title insurance, escrow fees, documentary transfer taxes and recording fees. Operating expenses such as HOA fees, prorated property taxes, prorated mortgage interest, prorated rents, etc., can be paid out of the net proceeds but will be taxable.

What happens to the funds during the exchange period?

The funds from the sale of your relinquished property are usually held by a qualified intermediary during the 1031 exchange period. The qualified intermediary is a neutral third party who is not allowed to have any prior business relationship with you.

 

The funds are held by the qualified intermediary in a trust account until they are used to purchase the replacement property. This ensures that the funds are not commingled with your other assets and that they are used for the intended purpose of the 1031 exchange.

 

I recommend Exeter 1031 Exchange Services which is a great qualified intermediary, in part because they spread out their client's funds to 8 different bank accounts which would provide $2,000,000 in FDIC coverage. They are also licensed, regulated, and audited by the Wyoming Division of Banking, which provides third party oversight that most exchange services do not offer.

 

Can you 1031 your personal home?

No, you cannot 1031 exchange your personal home. In order to qualify for a 1031 exchange, the property must be held for investment or business purposes. This means that the property can't be used as a primary residence or a second home.

 

There are some exceptions to this rule. For example, if you have a duplex and you live in one side of it while renting out the other, you may be able to do a 1031 exchange on the rental property side. Similarly, if you have a vacation home that you rent out for part of the year, you may be able to do a 1031 exchange on the rental portion of the property.

 

Unfortunately, it's not possible to do a tax deferred exchange on personal property, such as art, jewelry, cars, or boats. In order for the property to qualify, it must be a rental property or used in your business.

 

If you're thinking about doing a 1031 exchange, experience matters. Make sure to speak with a proven qualified intermediary and work with a skilled real estate agent who understands the process so that your 1031 exchange can be successful and create wealth for generations to come.

When should I do a 1031 exchange?

A 1031 exchange can be a great way to defer capital gains taxes on the sale of an investment or business property. But it's important to understand why you want to do a like-kind exchange.

 

The best time to do a 1031 exchange is when you're selling an investment or business property and you're looking to reinvest the proceeds into another similar property. Another great time is you are at the end of a properties depreciation cycle. Even if you do not have a large real estate portfolio, many people who own multiple properties complete a 1031 exchange later in life to minimize disagreements between their heirs.

 

Scott Stollar is an accomplished Realtor® in San Diego, he is a great choice for anyone looking to do a 1031 exchange. He has a wealth of experience and knowledge in the 1031 exchange process and has helped countless clients successfully navigate this process. Call Scott today to learn how this process could benefit you.

 

This article is based on experience selling investment property. Please check with your CPA for tax advice.

Scott Stollar

760-697-5661

DRE 02136497

sellitscott@kw.com

www.sellitscott.com