You probably have heard the term “1031 Exchange” in regards to real estate but aren’t exactly sure what that means. If you have heard of it and understand the process, bravo! For most people, even some real estate investors, the 1031 Exchange process is not very well understood. Read on if you would like to know the basics of doing a 1031 Exchange and some common pitfalls.
The term 1031 Exchange comes from the IRS Code section that creates this tax deferral transaction (similar to 401k). 1031 Exchanges allow for a real estate investor to sell an investment property and roll over the proceeds into a new investment property without having to pay any capital gain taxes, as long as the purchased property is the same price or more expensive than the property that is being sold. The beauty of this is that theoretically you can continue doing these exchanges and defer paying capital gain tax until you’re ready to retire and pay taxes likely at the lowest capital gain tax rate. Keep reading for the steps involved.
Step 1. The property you’re selling must be an investment property (the “relinquished property”). This is pretty straight forward. The language used by the IRS is that the property is “held for productive use in a trade or business or for investment.” For most investors, this would be a residential income property (duplex, triplex, fourplex) or apartment building, or a commercial building. Problems arise when an investor tries to sell a vacation property and defer taxes by calling it an “investment” and do a 1031. It is possible to do this but there are some additional requirements that must be met and will not be addressed here.
Step 2. Find a Qualified Intermediary (also known as an “accommodator or facilitator”). The most important aspect of the Exchange is that the investor cannot take “actual or constructive” possession of the funds. The Qualified Intermediary not only receives the funds from the sale of the relinquished property but also sends those funds for the purchase of the replacement property, and handles the transfers of the properties in the exchange.
Step 3. Open an Exchange. There are different types of exchanges that qualify under Section 1031. The most common one is the “delayed” or straightforward exchange. This is where a relinquished property is sold and a replacement property is purchased. The seller of the relinquished property has 45 days from the closing of the sale to identify the replacement property. There are additional rules about the identification of the replacement property but the most important one is to identify that property within the time frame. If an identification is not made in time, the funds will be released by the accommodator subjecting the seller to all capital gain taxes from the sale.
Step 4. Close the Exchange. Once the property is identified and an escrow is opened, the transaction must close within 180 days. This time period runs concurrently with the 45 day identification period so the whole process must begin and end within the 180 day period. It’s a standard purchase transaction at this point. The difficulty usually arises in the identifying of the replacement property within the 45 days so once that happens, unless the property is a short sale or otherwise distressed it should be a fairly painless process.
Other issues to consider. There are some other intricacies that must be understood to conduct and complete a favorable 1031 Exchange.
Cash Boot: This refers to any proceeds from the sale of the relinquished property that are not used in the purchase of the replacement property. This cash boot is taxable at the applicable capital gains tax rate for the owner of the property.
Debt Boot: When a relinquished property is sold, the loan to value ratio of the replacement property must be the same as the relinquished property. If the property being sold is $100,000 and the loan amount is $40,000 then the LTV is 40%. If the replacement property is $150,000 then the LTV also needs to be 40% so there should be a loan of $60,000. If the LTV is not the same, say $50,000 instead of $60,000, then the owner of the property is taxed on the $10,000 difference at the applicable capital gains rate.
Vesting: The vesting of the relinquished property and the replacement property must be the same, meaning title must be held by the exact same person or entity. If not then the exchange will fail.
Investment Property Only: Only properties that are investments qualify for a 1031 Exchange. Primary residences do not qualify unless the primary residence is a duplex or triplex and the owner lives in one unit and leases out the others. The proportion of the property that is an investment will qualify for a 1031 but the portion lived in as a primary residence will not.
Finally it’s important that the exchange accommodator is competent, reliable and properly bonded and insured. They should have attorneys and accountants on staff that assist with the exchange. There is a lot of documentation that must be generated and completed, and since you are dealing with the IRS you want trusted individuals representing you.
Conducting a 1031 Exchange can be a valuable part of building wealth but it must be done correctly.