Real estate investing offers numerous tax incentives, including the tax-deferred exchange known as a 1031 exchange.
Since the enactment of the Tax Cuts and Jobs Act (TCJA), real estate is the primary investment asset eligible for tax deferral via an exchange. Other common types of investment, like stocks and bonds, are not eligible for a 1031 exchange. This positions real estate as an ideal investment for wealth building.
This guide will explain the steps and requirements for a 1031 exchange, but please note that it is not a substitute for professional tax advice.
What is a 1031 exchange?
Derived from section 1031 of the Internal Revenue Code, a 1031 exchange is a tax break that allows you to defer capital gains taxes when you sell an investment property and reinvest the proceeds into a “like-kind” property of greater or equal value.
There is no limit to the number of 1031 exchanges you can claim, so you can postpone tax liability indefinitely by reinvesting. In the future, if you leave the property to your heirs, they will inherit the property at the current fair-market price without paying the deferred taxes. This makes real estate the perfect investment asset to build generational wealth.
1031 exchanges can also help to avoid depreciation recapture. When a property is sold, the IRS will normally recapture some of the previous depreciation deductions into the total taxable income. With a 1031 exchange, the second property assumes the cost basis of the first, and your depreciation continues as if you still owned the original property. There are some exceptions to this rule, so it is strongly advised to seek professional help.
4 Types of 1031 Exchanges
The property transactions in an exchange can be structured in various ways:
- Delayed exchange. One property is sold first and the replacement property is bought within a 180-day window. This is the most common type.
- Simultaneous exchange. Both transactions happen at the same time.
- Delayed reverse exchange. The replacement property is purchased before the sale of the original property. You must transfer the new property to an Exchange Accommodation Titleholder(EAT), select a property to exchange within 45 days, and complete the sale within 180 days of the replacement property purchase.
- Delayed build-to-suit exchange. The sale proceeds are used to finance a new property built to match the investor’s needs.
1031 EXCHANGE STEPS AND TIMELINE
Follow these steps to claim the tax benefits of a delayed 1031 exchange:
- Determine which property to sell. The investment property cannot be your primary residence, and it should have increased in value since the purchase.
- Hire a qualified intermediary (QI). This individual or business will facilitate the 1031 exchange, making sure all rules are followed. You can find a QI through the Federation of Exchange Accommodators.
- Sell your property. Sale proceeds (minus costs) have to be held in escrow by the QI before being reinvested in the new property. Funds cannot be received directly, or you will be responsible for capital gains.
- Select replacement properties. Within 45 days of selling the relinquished property, provide a written list of potential replacement properties. You can list up to three properties, regardless of their fair-market value, or you can list more than three properties if the aggregate value is not greater than 200% of the sold property’s value.
- Purchase a “like-kind” property. Within 180 days of the sale, purchase one of the replacement properties from step 4. The QI will then transfer the funds from the sale to pay for the replacement property.
- File your taxes with the IRS. Submit Form 8824 to inform the IRS of the exchange and properties. Provide descriptions of the properties exchanged, the date they were identified and transferred, the value and adjusted basis of the like-kind properties, and any liabilities assumed or relinquished.
- Hold onto the property. Don’t change ownership straight away, as you need to demonstrate your intent to use the new property as an investment.
QUALIFICATIONS FOR 1031 EXCHANGE REAL ESTATE
To be eligible for a 1031 exchange, the following conditions must apply:
- Investment properties. The properties must be used for business or investment. This could be anything from small medical offices to large apartment buildings. Personal properties do not qualify.
- “Like-kind” properties. This does not require buying and selling properties of the same type and quality. Rather, the term ‘like-kind’ refers to the property’s general nature. A wide range of real estate can qualify, as long as it’s used for business or an investment.
- Maintain value. To qualify for a 1031 exchange, the net market value of the purchased property must be the same or greater than the sold property.
- Full reinvestment. To fully defer capital gains tax, all of the equity from the relinquished property must be reinvested into the replacement property. If you pull any equity out through the exchange, you may be liable for taxes.
- No leftover value. “Boot” refers to any additional value gained in an exchange, excluding the like-kind property. If you have cash left over after purchasing the replacement property, or if your liability/debt decreases, that would generally be taxed as a capital gain.
- Taxpayer name. The tax return and the name on the relinquished property’s title must be the same as those for the new property.
- No personal exchanges. Both the sale and purchase need to be arm’s length transactions, meaning you can’t exchange directly with family members or people you have a personal relationship with.
WHEN TO NOT CLAIM A 1031 EXCHANGE
There are some scenarios in which a 1031 exchange is not recommended. If you invested through a qualified retirement account, like a self-directed IRA, you won’t need to file a 1031 exchange as it is already tax-deferred.
Additionally, if you haven’t owned the property very long, then depreciation recapture and property appreciation will be minimal. In this case, the 1031 exchange transaction costs would likely exceed the tax owed.
A strategic investing approach can help you maximize your retirement income while minimizing your investment taxes. By following these timelines and rules, you can use the 1031 exchange to defer capital gains tax and depreciation recapture for your property. However, the complex rules and exceptions will require professional help to avoid costly mistakes.
Investors often struggle to find suitable replacement properties and to manage the properties after purchase. If you are looking for a more passive, hands-off approach to real estate investing, consider investing through a syndication firm, like Yankee Capital Partners.