A “1031 exchange” is a nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. To many real estate investors, it’s an incredibly useful tool, especially when trying to leverage their rental properties.
Basically, it can allow an investor to save up to 30% in combined state and federal taxes.
A 1031 exchange occurs when an investor sells one investment property and purchases a different one. Theoretically, as an investor, you could be able to defer the capital gains on the sale of your rental property until your death.
It’s arguably a great investment strategy and is behind the success of countless real estate gurus.
Here’s a basic overview of 1031 Exchange for real estate investing.
Broadly speaking, 1031 is a swap for like-kind properties. While most exchanges are taxable as sales, those meeting 1031 requirements attract little to no tax during the exchange.
In effect, your investment can take a different form without cashing out or experiencing a capital gain. This will allow your investment to continue growing without the IRS seeing it.
There is no limit to how many exchanges you can do. Although each exchange may result in profits, you may be able to avoid paying taxes until you later decide to sell it for cash. Even then, you’ll only be required to pay only that one tax. Currently, that tax would be anywhere between 15 and 20% depending on the income – and 0% if you qualify as a lower-income taxpayer.
For an exchange to be successful, both properties must be “like-kind”. “Like-kind”, however, doesn’t take a literal meaning. The term is broad, and in real estate transactions, it means that the original and replacement properties must be similar in terms of character and nature.
So, in a 1031 exchange, it’s possible to exchange raw land for an apartment building. You may find the rules to be surprisingly liberal, but both properties must be located in the U.S.
1031 Exchange Qualifications
For a property to qualify for a 1031 exchange, it must either be an investment or used for business. The following is a list of properties that won’t qualify for a 1031 exchange.
- A personal residence
- A fix-and-flip property
- Second homes
- Vacation homes not used as rental properties
- Land meant for resale
- Notes, bonds, and stocks
Essentially, for a property to qualify for exchange, the transaction must be an exchange and not a sale. The following are some examples of property exchanges that could qualify for a 1031 exchange.
- Exchanging a shopping center for an office
- Exchanging raw land for a shopping center
- Exchanging an industrial building for raw land
- Exchanging an industrial building for an apartment building
- Exchanging an office building for a farm or ranch
From the examples above, two things should be apparent. One, both properties are either used for investment purposes or for productive use in a business or trade. And two, the properties are “like-kind”.
Deadline for Purchases
While 1031 exchanges can be worth thousands in tax savings, you need to have the timelines right.
When should you start shopping?
After selling an investment with the intention of completing a 1031 exchange, the sale proceeds will go to an intermediary. The qualified intermediary will then hold on to the funds until the transfer is done to the seller.
From the closing day, you’ll have 45 days to identify a maximum of 3 replacement properties. This may sound easy but usually isn’t – especially in a seller’s market.
When do you need to close on a replacement property?
You have two options in this regard. One option is by the due date of your tax returns, including extensions, for the year of the original sale. With the other option, you must buy the new property within a period of 180 days after selling the original property.
Here’s an example:
Suppose you are selling an investment property and want to capitalize on a 1031 exchange. Now, if you identify the property on, say, April 1st, then you’ll have up to May 15th of that year (in 45 days) to identify up to 3 replacement properties.
Then, you’ll need to close on the property by September 27th of the same year (180-days after the sale). This process will have met the requirements of a 1031 exchange. And remember, though, the properties being exchanged must be “like-kind”.
The term boot refers to non-like-kind property that is received in exchange. Boot can take the form of debt relief, an installment note, personal property or cash. The valuation of the boot is also done as per the “fair market value” of the non-like-kind property received.
Boot can be taxable to the extent of the capital gain one realizes on the exchange.
Here’s an illustration of how a cash boot can occur.
Suppose you sell a property for $400,000 and then buy a replacement property for $350,000. This becomes a partial exchange, as the prices don’t cancel out. A complete 301 exchange occurs when the sale price equals to the buying price.
The remaining $50,000 becomes a cash boot, and it is taxable.
Planning to exchange a depreciable property? If so, you need to be aware of some special rules. Exchanging a depreciable property can trigger a depreciation recapture.
Generally speaking, you can avoid this recapture by swapping one building for another like-kind building. However, if you exchange improved land with a building for unimproved land without a building, any claim you may have previously made on the building can be considered ordinary income.
1031 exchange can be a great option to increase your cash flow by deferring taxes. Savvy real estate investors have used it for decades. However, before embarking on the process, make sure you understand a few things. If you need more help determining if 1031 exchange applies to your situation, reach out to McCaw Property Management today!