When people hear the term “1031 Exchange,” they often perceive it as challenging due to the assumption that finding a direct exchange partner might be difficult. However, Section 1031 of the tax code, established by the IRS, provides specific guidelines for implementing a real estate 1031 Exchange. If you own investment real estate and aim to advance your position on the investment ladder, a 1031 Exchange could be an ideal strategy. This exchange enables you to sustain your real estate investment while postponing taxes on any gains, facilitating faster progression on the investment ladder. By deferring taxes during the exchange to a larger property, you enhance the velocity of your money and foster accelerated investment growth. This initial form of a 1031 Exchange is referred to as a Forward Exchange.
What is a 1031 Exchange?
A 1031 Exchange is a transaction where the IRS allows you to sell a real estate investment, not your personal residence, and replace it with another, without paying 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 would 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 first property, you don’t have an exchange property selected, your exchange will be disallowed and tax will be due. That 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. It doesn’t have to be a land-for-land or condo-for-condo exchange.
Must be Qualifying Property
Must be a 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 that is not “like-kind”. If the seller desires some cash or debt reduction this is okay as long as the seller realizes some tax will be due. You don’t want to receive any boot if you want the transaction to be 100% 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 pro-rations, 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 what is called 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 were 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 Opposite of a Forward Exchange!
The IRS also allows what is known as a reverse exchange. In this case, the replacement property is purchased—through the Exchange Intermediary—prior to the first property being sold. The Intermediary takes title to the property and holds it until the investor can find a buyer for the first 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. The fees involved are also more expensive than for a Forward Exchange. This is an extremely useful tool in a hot market where the seller of a replacement property will not wait for you to sell your old property.
This is an exchange when the relinquished property and the replacement property closings both occur on the same day. An exchange like this is amazing, if you can get real estate owners lined up who literally are going to exchange their property. Most exchanges are accomplished using the Delayed Exchange rules.
This is the typical exchange where the taxpayer has 45 days after closing the relinquished property to identify the replacement property and 180 days to get it closed.
A construction exchange would be when you sell your first property, and for example, exchange it for a piece of raw ground and use part of the proceeds to buy the land and then use the remainder to build structures.
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. Enough of the improvements would need to be done before the 180 days have passed to equalize the exchange.
Let’s say that you have been investing in real estate by buying 1 rental home every 2 years for twenty years. You now have 10 rental homes and you are ready to make your real estate investment more efficient. You decide to exchange those 10 rental homes for a 20-unit apartment building. This is known as a consolidation Exchange.
This is going the opposite direction from a Consolidation Exchange. For example, you own a 20-unit building that has been hit twice by a hurricane. As a result, you decide to exchange it for 10 rental homes in various locations across the country to spread out the risk.
Check it out
This was a brief overview of the 1031 Exchange concept. There are many other details about a 1031 Exchange that you need to review and consult with your tax professional to determine what works best for you.
By Duane Duggan. Duane graduated with a business degree and a major in real estate from the University of Colorado in 1978. He has been a Realtor® in Boulder since that time. He joined RE/MAX of Boulder in 1982 and has facilitated over 2,500 transactions over his career. 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.