A 1031 Exchange is a very useful real estate practice that can save you money and are a great way to get around not having enough funds to invest as well as the low liquidity of real estate. It’s a commonly used technique highly adaptable technique
What is a 1031 Exchange?
A 1031 Exchange is a tax-deferment strategy.It gets its name from the section of the IRS code in which it is found. It’s also known as a Starker Exchange and a Like-Kind Exchange. With a 1031 exchange you don’t have to pay capital gains taxes so long as the profits from the sale of your investment property is used to purchase a “like-kind property”.
When To Do a 1031 Exchange?
A 1031 exchange is good for more than just avoiding capital gains taxes. You could sell a high maintenance property in exchange for a low maintenance property, and that’s a big deal!
How To Do a 1031 Exchange Right Now?
In order to make a 1031 exchange right now you’ll need to find a replacement property with a cost that’s equal to or greater than the cost of your replacement property.
4 Types of Real Estate Exchanges
If a 1031 Exchange only allowed for swaps that occur immediately then they would be practiced far less often than they are. Luckily, like many investment practices, a 1031 Exchange has enough flexibility to be accomodating.
Simultaneous Exchange
A simultaneous exchange occurs when both properties close on the same day. It has to literally occur simultaneously. Even a short delay like wiring money could end with you having you pay the capital gains taxes you wish to avoid. There are three ways a simultaneous exchange could go down. You could swap deeds directly; you could have a third party that makes the swap happen; or you could have an intermediary who organizes the swap.
Delayed Exchange
Since the chances of finding a property you want that’s like-kind isn’t super high, often times 1031 exchanges are what is known as delayed, three party, or Starker exchanges (Starker being the name of the first time such an exchange occurred). In this sort of exchange, a third party will hold your cash after your sale in order to buy the like-kind property at a future time.
Reverse Exchange
Also known as a forward exchange, a reverse exchange is when you get the replacement property before you pay for the replacement property. The tricky part is that the payment has to be made entirely with cash. On top of that, most banks won’t offer loans for reverse exchange. You have 180 days to close the property that you’re providing for the swap. Otherwise the exchange is over. Not only that, but within 45 days you need to have identified which of your properties is going to be the “relinquished property”, and after that you` have 135 days to complete the swap (which, when combined, adds up to the aforementioned 180 days).
Construction or Improvement Exchange
A construction or improvement exchange uses some of the same mechanisms as a reverse exchange. You can use your tax-deferred profits to repair the replacement property while it’s held by a qualified intermediary for a portion of the 180 days. There are three stipulations that must be met in order for the improvement exchange to occur. Either all of the money must be spent on the improvements or it must be used as part of the down payment by the 180th day. By the 45 day, the person who’s being traded with must receive a like-kind property. And, the replacement property must be of equal or greater value to the relinquished property. The improvements must be finished before the other party gets the deed from the qualified intermediary.
1031 Exchange Rules Explained
A 1031 Exchange may be of great benefit but it’s not as simple as a simple swap!
Rule 1: Like-Kind Property
What it means to be a like-kind property is to be “the same nature or character, een if they differ in grade or quality.” So long as it’s not personal property and it’s in the U.S. , you can exchange any type of real estate!n You can even exchange multiple properties to get a single property! This may be useful if, for example, you have several homes you’re renting but want an apartment complex.
Rule 2: Investment or Business Property Only
As already mentioned, the property swapped cannot be personal. That means you can’t swap your primary residence for another property that you own. A 1031 Exchange nis for business or investment properties only.
Rule 3: Greater or Equal Value
The IRS stipulates that in order to get 100% of the tax deferred that the property being swapped must have a net market value or equity that’s equal to or greater than the property being obtained.
Rule 4: Must Not Receive “Boot”
If the property you’re swapping for is of lesser value, then you’ll have to pay capital gains taxes on the difference. That difference is known as the “boot”.
Rule 5: Same Tax Payer
When conducting a 1031 Exchange, the name appearing on the relinquished property must be the same as the name on the relevant tax return. The same name must also appear on the tax return and the title for the acquired property. The exception is a single member limited liability company (smllc), and that’s because its understood that the smllc is a pass-through for the person in question.
Rule 6: 45 Day Identification Window
Within 45 days of closing the relinquished property, you have to have identified up to three like-kind properties that you may acquire. This is easier said than done because the swap has to make sense financially, and, unfortunately, it’s not uncommon for people to overprice their properties when the interest rates are low.
Rule 7: 180 Day Purchase Window
You have upwards of 180 days or the due date of your income tax returns (even if you’re making use of extensions), or whichever comes first, to finalize the exchange. So if your tax due date for the year in which you sold your property is coming up in two weeks, you have two weeks to finalize that exchange, even if that’s less than 180 days!
Special Rules for Depreciable Property
Depreciation is the portion of what your real estate investment is worth that you can write off your taxes every year in order to account for wear and tear. When you sell a property, the capital gains taxes you pay are net-adjusted, which means it’s the original price you paid, plus capital improvement with the depreciation subtracted.
If you sell your real estate for more than its depreciated value, then the amount of depreciation will be counted as part of your taxable income when you sell the property. This is known as recapturing depreciation. Since the amount you’d have to pay as a result of depreciation recapturing goes up with time, a 1031 Exchange is a way to avoid an increase in your taxable income. Although, it must be noted that you won’t be able to avoid recaptured depreciation 100%
1031 Timeframe Regulations
It bears repeating: you need to find your replacement property within 45 days and the swap must be completed within the remaining 135 days. You have some wiggle room because by the 45th day you can have upwards of three potential properties. Although, thanks to the 200% rule, you can swap for an unlimited number of properties so long as their combined value isn’t 200% of the relinquished property’s worth. You can swap you property for as many as you can so long as the properties you get cost at 95% or more of their actual value.
1031s for Vacation Homes
A vacation home can be used in a 1031 Exchange so long as it meets the following criteria.
If you’re the owner then you must have owned the property for at least 24 months preceding the exchange. For each of the 12-month periods, the property has to have been rented at fair prices for 14 days or more (the last 12 months end the day before the swap, and the first 12 months end right before the last 12 months begin). And, lastly, during the year that the property is rented, you have used the property for no more than 14 days or 10% of the total number of days that the property was rented (so if you use the home for 20 days you had to have rented it for 200 days during the 12 month period in which it was used for 20 days).
Once you have the replacement property, you must hold it for at least 24 months. For each of the two-12 month periods, you must rent the home for a fair price for 14 days or more. Lastly, you can’t use the vacation home for more than 14 days or 10% of the number of days that the vacation home was rented for.
Tax Implication and Mortgages
If there’s any extra cash after you or the intermediary gets the replacement property, you’ll get that money by the time the 180 days are up. This extra money, however, will count as a boot and will be subject to taxation.
If a portion or the whole of the profits from the sale of your relinquished property goes toward paying off an existing mortgage, then the money you earned will become taxable. This is even the case if the replacement property is equal to or greater in value than the relinquished property.
One way to remedy this predicament is to go through the 1031 Exchange and then do a cash-out refinance, which is when you refinance your home and the new mortgage you get has more money than you need for the mortgage so that you have money to, for example, pay off debts.
Another way the 1031 Exchange can help you avoid paying taxes is by what happens when you die while still owning a property you got through a 1031 exchange. You die and your heirs get the property, but they don’t have to pay the deferred taxes!
IRS Forms for 1031 Exchanges
To complete a 1031 Exchange you’ll need the following forms:
- Publication 544: Sales and Other Dispositions of Assets
- Form 8824: Like-Kind Exchanges
- Form 4797: Sales of Business Property
Alternatives to 1031 Exchanges
A 1031 Exchange has a lot of rules, and even though 180 days may seem like a lot of time to wrap the whole thing up, the time restriction does put you at risk of settling for a bad deal. Luckily, you can do a structured sale.
A structured sale is when your capital gains are recognized, but the taxes you would pay on them are deferred until a later date of your choosing. You receive the profit from your sale in installments and pay the capital gains taxes accordingly, although you still have to pay the depreciation recapture taxes as you normally would.
1031 Exchange Rules, A Recap
As you can see, a 1031 Exchange is an involved process with lots to keep track of! The main thing to remember is that it’s a way to swap your property for property that’s of equal or greater value without paying capital gains taxes (so long as they’re investment or business properties). 1031 Exchanges can be a great help if you know how to use them! And part of knowing how to use a 1031 Exchange is consulting with a tax expert and an attorney to make sure everything is copacetic.
