A common tool for real estate investors, the 1031 Tax Deferred Exchange allows the investor to defer capital gains taxes on their investment properties if those gains are “re-invested” into a “like-kind” property. This is a wealth-building tool that ultimately gives you 15-35% more cash to put towards your next investment. This tax deferral is what allows investors to build bigger and bigger portfolios.
The 1031 Exchange is not a tax avoidance mechanism, rather it is a way to defer tax on your gains until you eventually sell or downsize your investment portfolio. When used correctly, it is an excellent mechanism to keep your money growing out of the reach of Uncle Sam.
Internal Revenue Code (IRC) Section 1031 – allows an owner of property held for productive use in a trade or business, or for investment, to defer payment of taxes on gain realized in the sale if they exchange for like-kind property. The tax is deferred (but not avoided) by transferring the basis in the relinquished property to the replacement property.
Again, this is a tax benefit for investors only – and the exchange cannot be used for properties you intend to live in. Two categories of property qualify for exchange treatment:
- Property held for investment, or
- Property held for productive use in trade or business
- Commercial property, such as office, manufacturing, rental
- Vacant land
- Apartment buildings, duplex/triplex/fourplex, rental homes
- Mixed use (investment & personal use)
- Agricultural land
NON-Qualifying properties include:
- Property held for personal use – this may include a second home or vacation property
- Property held primarily for sale – for instance a rehab or “flip” property
How it Works:
- First step – You should speak to your tax or legal advisor to understand the benefits as they relate to your specific circumstance. This is not a strategy you want to goof up, as the tax consequences can be severe.
- Consult a 1031 Exchange Company – you will want to have them on board to facilitate the transaction and they can work hand-in-hand with escrow.
- Start looking at exchange properties. Given the very short timeframe of an exchange, you will need to start shopping exchange properties as early as possible. You don’t want to sell your investment and then run out of time to find its replacement, as you’ll be stuck with a fully taxable event.
- Understand the three basic rules, or risk paying capital gains taxes:
- Use all the cash in the exchange account to acquire the replacement property
- Have equal or greater debt on the replacement property
- Purchase only like-kind properties
- You must have exchange documents drawn up PRIOR TO CLOSING the sale of the relinquished property – or the sale will be fully taxable.
- Your exchange funds can only be used to pay for:
- Earnest money deposits for replacement property
- Replacement property
- All typical and ordinary closing costs (although there may be rules about using funds for appraisals and loan fees – check with your exchange facilitator.)
- There are set timelines that must be adhered to. The clock starts ticking the date the relinquished property closes with the new buyer.
- 45 day rule – the Exchanger must identify the potential replacement property(s) within the first 45 days.
- 180 day rule – the Exchanger must acquire the replacement property within this period of time. (This timeframe could be shortened if your tax return is due within this time span.)
- There are some very specific rules around identifying your “replacement properties” – with both how many to select and how to select them.
- Keep all your records and consult a CPA at tax time. This is not like buying your house, where you toss your closing documents in a drawer and forget about them. Accurate record keeping is essential to maintain your tax-deferred status, and tax return preparation becomes non-trivial when you start introducing 1031 Exchanges into the mix.
It’s best to consult your real estate agent or 1031 Exchange Facilitator with specific questions. We recommend Exchange Facilitators or Investment Property Exchange Services as trusted Exchange companies.