Learning about the 1031 exchange process can confuse many investors, especially new ones. The more you know about the exchange process, the better equipped you will be to maximize your investment return and minimize taxes in a real estate deal.
Whether you’re a small business, entrepreneur, or investor, this comprehensive blog will take you through the 1031 exchange rules and every situation that may arise.
1031 Exchange Overview
What is a 1031 exchange?
According to Investopedia, “A 1031 exchange is a swap of one real estate investment property for another that allows capital gains taxes to be deferred.”
To elaborate, if you make a profit on the sale of a business or investment property, you must report it. Generally, the gain must be taxed at the time of sale. IRC Section 1031 allows you to defer paying tax on the gain if you reinvest the proceeds in the comparable property as part of a qualifying like-kind exchange. The deferred gain in a like-kind exchange under IRC Section 1031 is tax-deferred, it is not tax-free.
In order to make use of IRC Section 1031, real estate investors must first understand all of its components. Exchanges can only be made with like-kind properties, and IRS rules restrict their use to vacation properties.
Participants of a 1031 Exchange
Section 1031 deferrals may be usable to owners of investment and commercial property. Any taxpaying entity, including individuals, C corporations, S corporations, general and limited partnerships, limited liability companies, trusts, and others, may arrange an exchange of one business or investment property for another under Section 1031.
Qualified “Like-kind” Properties
You must meet certain requirements for both the replacement property you buy and the relinquished property you sell.
In both cases, the property must be held for commercial or investment purposes. Personal property, such as a primary residence, a second home, or a vacation home, does not qualify for like-kind exchange treatment.
The exchange of real estate and personal property is allowed under Section 1031, but real estate cannot be like-kind to personal property. The rules governing what qualifies as like-kind in personal property exchanges are more stringent than those governing real property exchanges. Cars, for example, are not interchangeable with trucks.
The provisions of Section 1031 do not apply to:
- Inventory or stock in trade
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Certificates of trust
1031 Exchange Timelines
If you exchange like-kind properties, you must meet two-time limits, or the entire gain will be taxed. Except in the case of presidentially declared disasters – and only if there is a disaster – these limits cannot be extended for any circumstance or hardship.
45-Day Rule: Identification Period
When you sell a property, you may be required to identify potential replacement properties within 45 days. The identification must be in writing, signed by you, and delivered to a participant in the transaction. Notice to your attorney, real estate agent, or an accountant acting as your agent, on the other hand, is insufficient.
The written identification must include a detailed description of the replacement properties. In real estate, this means a legal description, street address, or distinguishable name. Follow the IRS guidelines for identifying the maximum number and value of properties.
180-Day Rule: Exchange Period
The second restriction states that the exchange must be finished no later than 180 days following the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever comes first. Property identified within the 45-day window mentioned above must be substantially identical to the replacement property received.
Restrictions on the Exchange Process
It is critical to understand that taking possession of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and result in ALL gains being taxed immediately.
The exchange will still be considered to be of like kind even if cash or other proceeds other than like-kind property are received at its conclusion. Gain might be taxed, but only to the extent that the proceeds are not of like kind.
Using a qualified intermediary or another exchange facilitator to hold the proceeds until the exchange is complete is one way to avoid premature receipt of cash or other proceeds.
You can’t be your own facilitator. Furthermore, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee, or anyone who has worked for you in those capacities in the previous two years) is not permitted to act as your facilitator.
Selecting a qualified intermediary should be done with caution, as there have been recent instances of intermediaries declaring bankruptcy or otherwise failing to meet their contractual obligations to the taxpayer. As a result of these circumstances, taxpayers have failed to meet the strict timelines set for a deferred or reverse exchange, disqualifying the transaction from Section 1031 gain deferral. While any losses incurred by the taxpayer would be taken into account under different code sections, the gain might be taxable in the current year.
There is also a possibility of buying the replacement property before selling the old one and still qualifying for a 1031 exchange. This case also falls within the 45- and 180-day time frames.
To be eligible, you must transfer the new property to the titleholder of an exchange accommodation, choose a property to exchange within 45 days, and finalize the exchange within 180 days of purchasing the replacement property.
Reporting 1031 Exchanges to IRS
Exchanges must be reported to the IRS on Form 8824, Like-Kind Exchanges, and filed with your tax return for the relevant year.
Form 8824 asks for:
- Descriptions of the properties exchanged
- Dates that properties were identified and transferred
- Any relationship between the parties to the exchange
- Value of the like-kind and other property received
- Gain or loss on sale of other (non-like-kind) property given up
- Cash received or paid; liabilities relieved or assumed
- Adjusted basis of the like-kind property given up; realized gain
You may be held liable for taxes, penalties, and interest on your transactions if you do not strictly adhere to the rules for like-kind exchanges.
DOWNLOAD Form 8824 here.
Advantages of 1031 Exchanges
Both new and experienced investors benefit from the 1031 tax-deferred exchange. It makes sense given the strong economic growth and property appreciation that we have seen in many areas throughout the county over the last several years. A 1031 exchange can offer the advantages of leverage, increased cash flow and income, management relief, consolidation/ diversification, and it can significantly increase the investor’s purchasing power.
To acquire a more valuable investment property, investors can use the 1031 tax-deferred exchange. They can increase their down payment and overall buying power by using the money they would have paid to the IRS in taxes to purchase a more expensive replacement property. As a result, they are leveraging their cash and accumulating wealth through real estate investment.
INCREASED CASH FLOW/ INCOME
A 1031 tax-deferred exchange can increase both cash flow and overall income. A vacant parcel of land, for example, can be exchanged for a commercial building that generates cash flow and depreciation benefits.
Investors who own multiple rental properties are frequently burdened by the burdens of intensive management and costly maintenance – which frequently leads to increased headaches! Exchanging out of high-maintenance rental properties and consolidating into an apartment building or NNN leased investment can increase profits while decreasing time and effort.
An exchange allows an investor to trade one property for several others, consolidate multiple properties into one, and acquire property anywhere in the United States. An investor, for example, can exchange two duplexes for a retail strip center or capitalize on a new growth area by exchanging one property in California for three properties in Arizona.
INCREASED PURCHASING POWER
The figures in the example demonstrate the financial strength of a 1031 exchange. Capital gains are taxed at a maximum capital gains tax rate of 20% federal, 12.3% state of California, and 25% recapture of depreciation. In this case, the total amount owed is:
20% of $375,000 = $75,000
12.3% of $375,000 = $46,125
25% of $35,000 = $$8,750
= $129,875 that is deferred through a 1031 tax-deferred exchange to increase purchasing power!
Source: First American Exchange Company
As agents dedicated to serving your future ownership dreams and protecting our clients,
we have 1031 exchange advisors who can answer your legal questions and discuss if a 1031 exchange
is the right move for you.
Give us a call at 949-541-8066.