As a real estate investor, you’ve no doubt heard of 1031 exchanges. The name originates from Section 1031 of the U.S. Internal Revenue Code, and for the past hundred years, has helped investors defer tax in like-kind transactions of investment properties.
Investors can strategically use the exchange to scale and optimize their portfolios and advance toward financial freedom.
To make a 1031 exchange work to your best advantage, it’s necessary to be educated and fully informed about the process.
What is a 1031 Exchange, and How Does it Work?
Investors who sell real estate assets are required to pay capital gains taxes on the sale profits. A 1031 exchange can defer these taxes, provided the proceeds get reinvested into a new property of the same type, at an equal or greater value, within a set time frame.
Here’s a summary of the 1031 exchange process:
- Choose a qualified intermediary to arrange the exchange
- Sell your relinquished property
- Within the following 45 days, locate potential replacement properties
- Within 180 days from the sale of your property, close on the purchase of your new property.
- File the IRS form 8824
It’s important to note that properties under a 1031 exchange must be considered the same type of asset in the eyes of the Internal Revenue Service (IRS) for capital gains deferral. Investors have virtually unlimited opportunities to use a 1031 exchange, except for vacation properties, and in some cases, primary residences.
Are 1031 Exchanges Complicated?
1031 exchanges can be complex, so it’s best to consult with a qualified tax professional before you begin.
For example, finding an asset that fits the IRS regulations of “like property” within a short time frame can be challenging, but is also a requirement if you want the deferred tax advantages of a 1031 exchange.
The rules are specific, so it’s helpful to be well versed in this type of transaction so that Uncle Sam doesn’t have any nasty surprises lined up for you on tax day.
When is a 1031 Exchange a Good Solution?
There are many reasons people choose 1031 exchanges:
- Diversification benefits or better return prospects of a similar property
- Transitioning from managing a property to investing in a managed property.
- Consolidating several properties into one, or dividing one property into several assets, for estate planning.
The key point here is that 1031 exchanges are powerful tax deferrals for investment properties. If you have good reason to reinvest in another property, then 1031 can offer a tax shield strategy that works to your financial advantage.
Choosing a Replacement Property
Interestingly, the definition of “like properties” is rather loosely interpreted by the IRS. Yes, a ranch and a strip mall are exchangeable. Yes, an apartment complex and a block of raw land are considered “like properties.”
The exchange can include multiple properties, and they can be situated anywhere in the U.S.
The Three-Property Rule
Closing a deal on a like property for a one-to-one exchange can be difficult to achieve in the 180 days of eligibility.
That’s where the three-property rule comes in handy. This rule means that rather than identifying only one property for your exchange and securing it, you’re allowed to target a maximum of three properties for reinvestment.
You have 45 days to identify three properties that you could potentially buy with the proceeds of your sale. While you don’t have to close on all three properties, the singular or combined purchase price of the properties must be equal to or greater than the property you sold.
The 45-day rule is strictly enforced: that is to say, you must disclose the addresses of three properties under consideration before the end of the 45th day from the sale of your property.
There are, however, a few loopholes to the three-property rule.
The 200% Rule
If you wish to target more than three replacement properties, this is permitted under the condition that the combined value of all properties you identify is not greater than 200% of the sale of your relinquished property.
For example, let’s say you sell an asset valued at $1 million, and identify four potential properties with the intention to close on some – but not all – of them within the 180 day period. The 200% rule means that the combined total of the four properties must not exceed a value of $2 million.
There is a condition of the 200% rule. It’s been rather “creatively” named the 95% rule.
The 95% Rule
The 95% rule is always triggered when you decide to opt for the 200% rule. They’re more like two elements of the same directive.
This obligation means that an investor must close on 95% of the targeted properties’ combined value within the 180-day closing period to reap the tax deferral benefits of the 1031 exchange.
As in our above example, this would require the investor to close on $1.9 million within the allocated six-month period. Failure to do so results in the annulment of a 1031 exchange, and a hefty capital gains tax bill.
1031 Exchange Tax Implications: Cash and Debt
You may have cash left over after the intermediary acquires the new property. Once the transaction has been finalized, the intermediary will pay this cash, known as “boot” back to you at the end of the 180-day period. This gets taxed as partial sales proceeds from your deal.
Bear in mind that any change in loans or debt value can also be considered “boot.” For example, in the case that you had a 1 million dollar mortgage for your first property, and can refinance your mortgage to $900k after the 1031 exchange, the $100k difference is treated as income and is taxable – just the same as cash.
Moving Into a 1031 Swap Residence
To qualify for a like-kind exchange, both the relinquished property and the replacement property must be held for productive use in trade or business, or as an investment. This can be referred to as the qualified purpose requirement.
But what if something changes and you are required to make your acquired property a primary residence instead?
Well, it all comes down to intent when you purchased the property. If you have displayed genuine intent to use the property as a rental by renting it out at market value for at least a year, you will likely have satisfied the requirement of genuine intent, before you can make it a primary residence property.
There is a harbor test to determine how long a property must be held as a rental before converting to a primary residence.
1031s for Estate Planning
One issue with 1031 exchanges is that eventually the string of tax deferring investments will end, and you’ll hit a nice big tax bill at the end of your run. But there’s a way to get around this with estate planning.
Any tax you’re liable to pay becomes voided upon the event of death. This means when investors leave a property they owe tax on to their beneficiaries, their inheritors won’t be liable to pay the tax owed. This means beneficiaries can inherit the property at its stepped-up market-value rate.
1031 Exchange on a Primary Residence
1031 exchanges are not permitted on primary residences, because they are not investment properties being used for business or trade purposes: they’re the home that you live in.
If you want to plan for a 1031 exchange in the future on your current primary residence, consider renting it out for a reasonable period and refrain from living there. Your primary residence may then be considered an investment property under IRS regulations, and become eligible for a 1031 exchange.
1031 Exchange on a Second Home
This rule is similar to the above rule. If you have a second home or vacation unit that generates revenue because you have been renting it out for a reasonable period, it may be eligible for a 1031 exchange. If, on the other hand, you’re holding the property for personal use and it’s not a revenue-generating investment property, it likely won’t be eligible for the exchange.
What Is 1031 Exchange Depreciation Recapture
Real estate investors can write off a certain amount of taxable income based on the asset’s depreciation, or the rate at which the asset endures wear and tear. For investment properties, this period is 27.5 years.
When a property is sold, the IRS tries to factor some of these write-offs and account them into the total taxable income value. 1031 can delay the recapture by transferring the cost basis from the old property to the new one. This shields the investor from a certain amount of taxes within the exchange.
Two Important Time Limits You Need to Know
The two timelines for the 1031 exchange are:
- An investor has a 45 day identification period from the point of sale to identify replacement property. Even if the 45th day falls on a public holiday or a weekend, the 45-day rule is strictly enforced.
- Within 180 days – which roughly translates to six months – from the point of sale of the asset, you need to have closed the sale on the replacement asset.
It’s important to note that the 45-day rule and the 180-day rule run concurrently. That is to say, both begin on the day the sale is made.
1031 Exchange Extension
Typically investors do not have access to 1031 exchange extensions to the 45-day rule or the 180-day rule.
However, given the uncertainty from the global pandemic, on April 9th, 2020, the IRS released an extension period (2020-23) for all 45-day and 180-day timelines of up to 120 days, to alleviate pressures driven by social distancing and lock-downs.
The extension period, however, finished on July 15th, 2020, and it is currently unknown whether or not there will be any additional extensions.
The intricacies of 1031 exchange regulations can seem complicated. When considering the financial benefits of a 1031 exchange – even in light of the strictly enforced rules – they often outweigh the potential risks and short timeframes.
Investors can use any number of 1031 exchanges to strategically defer taxes on a relinquished property and grow, or diversify their investment portfolios.
If you have lingering queries about the 1031 exchange or real estate tax relief, contact the team at Buy NNN Properties today. We’re here to guide you through your smart real estate investment choices!