Like with any other form of transaction, when it comes to real estate, the IRS identifies and collects its due tax for services the federal government has provided. Since real estate can actually generate gains for its buyers/sellers, the IRS categorizes this process under capital gain and taxes the parties involved accordingly.
However, there are some laws/regulations that can alter this process. These laws can prove profitable for those real estate investors trying to avoid being levied with capital gain taxes.
One very important law with such ability is the widely used Internal Revenue Code Section 1031, or the 1031 Exchange.
1031 Exchange: Kind-Like IRS
Section 1031 of the US Internal Revenue Code creates a window within the law framework for those trading in real estate to exchange their properties, fully or partially exempt from paying capital gain taxes.
Section 1031 states: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or investment.”
In essence, the IRS should acknowledge that the exchange is being done between “like-kind” properties. IRS should also recognize that if the properties are used for business, trading, or as investments, upon their exchange, they won’t be subjected to capital gain taxes.
There are, of course, exceptions in this scenario as the 1031 Exchange requirement and rules are subject to alterations and revisions. Here we will take a look at the basics, as well as the latest 1031 exchange process rules.
What Constitutes a 1031 Exchange?
When two owners decide to swap properties, you have a 1031 Exchange or a Starker. There are no sections in the Internal Revenue Code under “swap,” so there are conditions to be met in order to have a 1031 Exchange tax exemption/reduction. Otherwise, almost all swaps are subject to taxation.
The law’s clear text requires properties being exchanged to be “like-kind,” a somewhat misleading phrase. Especially when you learn that a residential building can be exchanged with something as widely different as, say, a mall.
As of January 1st, 2018, section 1031 has been altered to include only real property, excluding the exchange of intangible possessions like vehicles, machinery, artwork, patents, and things that can be collected, as the IRS no longer recognizes them as eligible for like-kind exchanges.
Also, intellectual property and intangible business capital are usually not considered subject to the non-recognition of gain or loss under the like-kind exchange exemption of the 1031 Section. However, certain possible exchanges of reservoir or irrigation stocks can be considered under the 1031 exchange rules.
A transition rule was added under the Tax Cuts and Jobs Act, Section 1031, that allows Section 1031 to be applied to exchanges of personal or intangible property, provided that the taxpayer gave away or received property in an exchange on or before December 31st, 2017.
In conclusion, if we were to try and be on the safe side, we must surmise that in the context of this Internal Revenue Code entry, like-kind simply means properties that are recognized as real estate across the fifty states of the United States of America, which reminds us of the very important rule that Section 1031 Exchange rules apply only to properties located inside the US.
What Constitutes Like-Kind Property?
According to the IRS’s entry as the definition for like-kind properties, “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.”
They continue to explain that real estate is almost always applicable to the term like-kind, despite the fact they are almost always different in one way or the other. This difference covers things like whether it is old or new, unimproved or improved, and even the real estate’s function.
What Are the 1031 Exchange Requirements?
Before getting too excited, you must know that only real estate recognized as an investment can be submitted as a 1031 Exchange. The first step is obviously deciding on the like-kind exchange and listing your property.
Then, you should find the replacement property. This could take a long time depending on the nature and quality of your property, as well as what you are looking for, the state you are in, and the market situation. Thereafter, you will want a registered and qualified intermediary professional.
After completing your property’s sale, you must identify properties that you are considering as replacements, start the process, and then finally, close on your replacement property deal to end the cycle.
What Are Some 1031 Exchange Basics?
Since the IRS looks at this process as an opportunity to enjoy limited tax exemption, with more stress on the “limited,” the federal government’s guideline allows up to three properties to settle on as replacement properties.
Therefore, as investors, you must be aware that to avoid further scrutiny and complicated regulations, you must limit yourself to up to three properties in your rollover process for finding the perfect replacement property.
Another rule among the 1031 exchange basics to follow is that your replacement property’s final value in the market must be twice the amount or lower than the property you are doing a 1031 Exchange on. This rule is dubbed the 200% rule.
Another rule that highlights the importance of knowing your plans beforehand is the IRS’s strict timeline that allows the identification and reporting of your replacement property only up to 45 days after selling your property. Be advised that it is 45 days and not 45 working days. So, act quick!
To keep the strict timeline tone consistent, the IRS also follows a 180-day deadline for closing on a replacement deal. This means that the day the selling of a property is finalized, you have six months, or 180 days to be exact, in order to close on your replacement deal.
So, How Many Ways Can You Do a 1031 Exchange?
The Section 1031 Exchange is regarded as a rather simple way to depreciate to save on and defer taxes (if any) on your possible gains. There are a number of ways you can do your 1031 Exchange.
Although rare, these transactions do take place, especially among those who have studied their options well and have landed on their final call. A simultaneous 1031 Exchange means the investor relinquishes their original property and closes on an alternative property on the same day.
Following the strict timelines upheld by the federal government, the investor is able to first sell their investment property and then look for, identify and close on their replacement property within 180 days.
The whole process is quite simple: “buy first and pay later.” In most cases, this is a total cash payment, so most banks would not be interested in lending. The impossibility of you simultaneously being on the title to both relinquished and replacement property makes it harder.
There is, however, a solution. You can set up an LLC to take over the title to the replacement real estate. Once you have sold the original property, transfer the title into your name.
Many investors sell their property only to find out that the cost of relinquishing is higher than what they intend to buy. Paying taxes by any means is not feasible. However, there is always an option for an improvement or construction exchange. This kind of exchange helps you invest the rest of the money on the real estate you are willing to buy.
With proper diligence and planning, 1031 Exchange properties for sale could be rewarding. They could turn out to be invaluable assets to foment your financial standing and stability in the long run.
When Should You Do a 1031 Exchange?
Rolling over revenue from an investment property you sell into another one without having to worry about the IRS wanting in on your capital gains is the appeal of a 1031 Exchange. You defer taxes of up to thirty percent on the sale of the property, only to turn your capital gains into non-taxable real estate investments.
Section 1031 Exchanges of properties can theoretically be your choice of investment for the rest of your life, meaning you can always defer taxes by avoiding selling your property into cash and instead using it to replace the original property with alternative properties.
Therefore, you are able to create and manage a real estate investment portfolio, tax-deferred and relatively constantly shifting to match your needs and bring about profits in the form of more valuable real estate investment properties.
This translates into possibly selling one big property and buying multiple properties of your choice without having to pay for your capital gains made from selling the property. Or conversely, you can relinquish several smaller properties and invest in one big strip mall.
When Can You Not Do a 1031 Exchange?
There are a number of minor details as to what and who qualifies for a 1031 Exchange. However, there are two major 1031 Exchange requirements for real estate property.
Thou Shalt Not 1031 Thy House of Residence
It is vital that the property you are considering for 1031 must be an investment property. Therefore, the exchange of a property owned by the people living in it is not admissible by Section 1031. Both the property that is being relinquished and the one that is being replaced must be registered as investments.
Thou Shalt Acquire Properties More Precious Than Thine
The whole point of the 1031 exchange is to benefit from capital growth without having to pay the taxes for capital gains. Therefore, the property that is replacing the original must be of a higher market value than the one you are relinquishing.
Additional Tips When Doing a 1031 Exchange
We have already covered the four most basic principles of doing a 1031 Exchange. Let’s do a short recap:
- The first is that you can identify up to three replacement property candidates.
- The second rule – the property you consider as a replacement can’t have more than twice the value of your original property. Remember the 200% rule?
- The third rule – you must identify at least one replacement property within 45 days of finalizing the 1031 exchange property sale.
- The fourth rule – after you have sold your 1031 Exchange Property, you have 180 days to close on a replacement.
Now we’ll dig deeper and talk about other details you should know when doing a 1031 Exchange.
The Shape-Shifting Like-Kind Rule
As mentioned earlier, like-kind can be generally interpreted as any property recognized as real estate property across the United States. However, it hasn’t always been like this, and some details have been modified.
The two major changes to Section 1031 of the tax code occurred in 1984 and in 2018:
- In 1984 the definition of the like-kind property considerably broadened. Before, a three-store strip mall could only be replaced with another three-store strip mall under the 1031 Exchange. After the 1984 adjustment, you could easily exchange a residential building with an industrial/business complex.
- The changes that became effective as of January 1st, 2018, limited the applicability of Section 1031 Exchanges to real estate properties, excluding personal, intellectual, and intangible properties.
The important thing is always to be fully informed and updated about the latest rules and regulations regarding 1031 Exchanges when considering a transaction.
Where Do Proceeds Go Between Selling and Buying?
The money that comes through from selling a 1031 Exchange property is held in escrow. It means a qualified intermediary third-party holds the proceeds in an independent account. They will then make the purchase for you once the replacement property deal is closed. Therefore, you cannot spend the money you’ve earned on a 1031 Exchange property on anything but the replacement property.
Higher than 200%?
There is a solution for anyone who doesn’t want to settle for only 200% of their original property value or simply wants to invest more of their capital without worrying about the capital gain taxes.
If you are okay with owning 95% of your replacement properties’ aggregate value, you can go with as many properties with as much value as you want, provided that you buy at least 95% of their aggregate value.
Growing a tax-deferred investment is an opportunity that shouldn’t be quickly passed up, especially in the real estate market, where the IRS closely observes every move. Rolling over each exchange’s possible profits makes 1031 Exchange an excellent plan for creating and efficiently managing a profitable real estate investment portfolio.
We attempted to shed some light on things to be aware of when considering a 1031 Exchange Property.
If you need to exchange your property, contact NNN Deal Finder now, and we’ll connect you with other real estate owners looking to exchange their property quickly.
It's absolutely possible to buy a property with a 1031 exchange, rent it out to tenants, and later move into the property yourself. The IRS has provided guidelines detailing how a 1031 exchange asset can be transformed into a primary residence without annulling the exchange.
The replacement property must be owned for a minimum qualifying period of 24 months immediately following the exchange. In each of the 12-month periods in the qualifying period:
- The taxpayer must rent the property for a minimum of 14 days at a fair rental rate.
- The taxpayer must not inhabit the property for the larger of either 14 days, or 10% of the number of days the property was rented to another party during the 12-month period.
It depends. While some tax and legal experts determine two years to be an appropriate window after which you can sell or further exchange a 1013 property, the answer lies in the intersection of timing vs intent.
When you sell a property that was your primary residence for a portion of the time you owned it, the capital gain you make is drawn from the entire period of ownership. However, the time you inhabited the property combined with the final 36 months before the sale, are exempt from capital gains tax.
For example, let's say you purchase a property as a primary residence for five years, then move to another home and hold the first property as an investment for five years. Eight out of the ten years of ownership would be exempt from capital gains tax. The first five years, because it was your primary residence, and the last three years, because that's what the rule says.
This rule has been used to exploit tax shields, by reporting a home as a primary residence for a short time (say a month), then changing primary residence and receiving the 36-month period CGT exemption.
The IRS does not permit 1031 exchanges with the intent of the property being used as a primary residence. This is because 1031 exchanges are specifically designed for real estate allocated to productive business or investment purposes.
Primary residences are used to provide shelter for your family rather than serve as an investment property. Even a vacation property is not able to be used for a 1031 exchange if it's not treated as an investment property for tax purposes. However, as outlined above, there are loopholes through which you can transform an investment property into a primary residence under certain conditions.
Basically, the requirement for a 1031 exchange is that an investment property used for productive business or trade can be exchanged for a property of equal nature and character, at an equal or greater value, to defer capital gains and depreciation recapture taxes. Provided the property was not used as a primary residence and is not intended for use as a primary residence or vacation property following the exchange, investors are free to defer capital gains taxes ad Infinitum.