The following article is the first of a series of articles about how to increase the velocity of your investment dollar through real estate.
1031 real estate exchanges
A 1031 exchange is a tax-deferred real estate transaction that “swaps” one investment property with another investment property under very strict IRS rules for the timeline and deadlines that structure the transaction.
When most people hear the words 1031 exchange, they think it sounds daunting because they wonder “who would want to exchange directly with me?”
In Section 1031 of the tax code, the IRS has outlined specific guidelines for a 1031 exchange. If you are the owner of an investment property and want to climb the investment ladder, a 1031 exchange could be just the ticket for you.
The 1031 exchange allows you to continue your investment in real estate, while deferring taxes on any gain, so that you can climb the investment ladder faster. By not paying taxes at the time of exchanging up to a larger property, you are able to increase the velocity of your money and your investment growth.
What is a 1031 exchange?
A 1031 exchange is a transaction in which the IRS allows you to sell a real estate investment and replace it with another without paying capital gains tax on the gain of the first property at the time of sale.
This tax concept allows you to keep trading up without having to write a check to the government each time you trade up. Sometimes these exchanges are called “tax free” but they are actually “tax deferred”. Tax is finally paid when you no longer want to be a real estate investor and are ready to “cash out”.
If the property is passed on to the heirs of the investor, it will be subject to the estate tax rules at the time of death. To qualify for a 1031 exchange there is a list of requirements, and most are easy to comply with.
General rules for a 1031 exchange
The current rule reads that upon closing the sale of the first property, the owner has 45 days to locate the exchange property and 180 days to close on it. Therefore, it is wise to talk with both your CPA and your Realtor® before selling and closing on your property. If 45 days after the closing of the sale of your old property you don’t have an exchange property selected, your exchange will be disallowed, and tax will be due. Those 45 days can pass very quickly.
The “like kind” rule of section 1031 of the code states that the properties exchanged must be “like kind”. This simply means that the investment must continue in real estate. For example, if you own vacant land, you can exchange it for an improved income-producing property such as an apartment building or an office building.
Must be qualifying property
Qualifying property is property held for investment or used in a taxpayer’s trade or business. Any “boot” received will be taxable. Boot is any property which is not “like kind”. If the seller desires some cash or debt reduction this is okay, as long the seller realizes some tax will be due. You don’t want to receive any boot if you want the transaction to be 100 percent tax deferred. A rule of thumb to defer taxes is to always replace the exchange property with one of equal or greater value and debt. You should bring cash to the closing of the exchange property to cover charges that are not transaction costs, such as utility escrows, rent prorations, etc. An exchange intermediary must be used to hold the exchange funds from the closing of the old property.
The exchange intermediary
In the typical exchange, you will be selling a property which you have been holding for investment. According to the IRS rules you cannot touch the money that comes from the closing of your former property. You need to hire an exchange intermediary. The intermediary will charge a fee for completing the exchange agreement and all the necessary paperwork. The intermediary will hold your cash proceeds until you are ready to close on the replacement investment property.
The exchange agreement
The agreement between the investor and the exchange intermediary contains an assignment of the contract to the intermediary. It allows the intermediary to hold the funds until the next closing. If the investor was to take receipt of the funds, a taxable event would occur. The deadlines for the identification and closing of property will be specified. It will allow the intermediary to disburse exchange funds to purchase the replacement property.
The reverse exchange
The IRS also allows for what is known as a reverse exchange. In this case, the replacement property is purchased, through the Intermediary, prior to the old property being sold. The Intermediary actually takes title to the property and holds it until the investor can find a buyer for the old property. After the replacement property is purchased, the investor has 45 days to identify the property that will be relinquished, and 180 days from the closing of the replacement property, to close on the property being relinquished. The reverse exchange creates some financing issues since lenders don’t like to lend money to the intermediary. Therefore, the investor typically needs to have the cash available to purchase the replacement property, or have a line of credit arranged.
This is an exchange when the relinquished property and the replacement property closings both occur on the same day. An exchange like this is excellent, if you can get real estate owners lined up who will literally exchange their property at the same time. Most exchanges are accomplished using the delayed exchange rules.
This is the typical exchange in which the taxpayer has 45 days after closing the relinquished property to identify the replacement property and
180 days to get it closed.
This is an exchange in which the taxpayer needs to enhance the property to create adequate value to close the exchange without creating a tax liability. The improvements need to be done before the 180 days have passed.
This article was just a brief overview of the 1031 exchange concept. There are many other details and intricacies to learn about. It’s advisable to consult with your tax professional and your 1031 intermediary company to determine what works best for you.
By Duane Duggan. Duane has been a Realtor since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail [email protected], call 303.441.5611 or visit boulderco.com.