HOW TO BUILD A REAL ESTATE EMPIRE USING 1031 EXCHANGES

If you own an investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. 

 

What is a 1031 Exchange?

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties like kind and equal or greater value. This allows investors to defer the capital gains tax from a sale of a property and invest the proceeds into another property, often called “trading up”.

 

What qualifies as a 1031 exchange?

A key rule about 1031 exchanges is that they’re generally only for business or investment properties. Property for personal use like your home, or a vacation house typically doesn’t count. Securities and financial instruments, such as stocks, bonds, debt instruments, partnership interests, inventory, and certificates of trust aren’t usually eligible for 1031 exchanges.

 

When To Use A 1031 Exchange

There are multiple reasons why you might want to use a 1031 exchange. You may want to:

• Invest in a property with better return prospects than your current investment property.
• Consolidate several properties into one, possibly for life estate planning purposes.
• Reset the property’s depreciation.
• Turn your vacation home into a rental property and do a 1031 exchange. (Here’s an example of how that can work: You stop using your beach house, rent it out for a few months, then exchange it for another property.)
• Sell your investment property and invest in more than one property. For example, you can buy three investment properties if you want to – there’s no limit. However, if you buy more than three, your qualified intermediary will have to go over some extra rules with you.

 

1031 Exchange Rules And Requirements

There are rules and regulations that pertain to a 1031 exchange, including property requirements and time requirements.

 

Property Requirements

The property you exchange must abide by certain requirements:

 

• The replacement property must be like-kind, or of equal or greater value to the relinquished property. Both properties must be similar enough to qualify as “like-kind.” Most real estate can be like-kind to other real estates. For example, real property improved with a residential rental house is considered like-kind to empty land. Note that property within the United States is not like-kind to property outside of the United States.
• The exchanged properties must be similar in nature and function. For example, a rental or multifamily property cannot be exchanged to acquire a vacation home. Personal use residences, such as a primary residence, second home, or vacation home, do not qualify as like-kind exchanges. Actual property and personal property (which can include machinery, equipment, collectibles, vehicles, boats, aircraft, artwork, patents, and other intellectual property) can both qualify as exchange properties under Section 1031 but actual property can never be like-kind to personal property. The rules are more restrictive for personal property as well. For example, cars are not like-kind to trucks.
• You cannot hold the money made from a sale during the exchange at any time. All funds must be held in escrow by a qualified intermediary or the proceeds will become taxable.

 

Finally, Section 1031 does not apply to these types of exchanges:

• Stocks, bonds, or notes
• Other securities or debt
• Partnership interests
• Trust certificates

 

Time Requirements

You must also adhere to specific timelines with a 1031 tax exchange or the gain on the sale of your property may become taxable:

You have 45 days after the sale of your relinquished property to find potential replacement properties. You must do so in writing and share it with the seller or your qualified intermediary.

You must close on the replacement property within 180 days of closing on the relinquished property or after your tax return is due.

 

Types Of 1031 Exchanges

Delayed Exchange

A delayed exchange is the most common exchange format because it offers you the flexibility of up to a maximum of 180 days to purchase a replacement property. If the relinquished property is sold before you acquire the replacement property, the sale proceeds go to your qualified intermediary. The qualified intermediary holds the money until you acquire the replacement property and your qualified intermediary will deliver funds to the closing agent.

 

Reverse Exchange

A reverse exchange, or forward exchange, involves closing on the purchase of the replacement property before you close on the sale of the relinquished property. You may want to tap into this option to get a desirable replacement property when it’s a seller’s market, especially if you encounter competing offers or a pressing need to close quickly.

When a replacement property is purchased before the sale of the relinquished property, again, the property must be transferred through an exchange accommodation titleholder to the qualified intermediary.

 

A Typical Example of the 1031 Exchange Process

The example below compares a typical sale and a 1031 exchange:

Jeff decided to sell the condominium he has owned for 6 years (relinquished property). The property’s current fair market value is $1,500,000; however, at the time he purchased the condo, the fair market value was $500,000. After Jeff spent $50,000 in capital improvements and the property depreciated by $80,000, his adjusted cost basis was $470,000. Jeff was advised by his tax consultant to engage in a tax-deferred exchange.

Jeff’s real estate broker discovered an apartment building for $2,750,000 (replacement property). Jeff purchased the property using the net proceeds from the sale of his condo within the 180-day period and successfully completed the 1031 exchange. If Jeff had sold his condo without using a 1031 exchange, he would have paid $144,500 in federal taxes.

Through the use of a 1031 exchange, Jeff deferred his capital gains and depreciation recapture taxes and had $144,500 more to invest into a replacement property.

 

 

What Is A Qualified Intermediary?

Under Section 1031, any proceeds received from the sale of property remain taxable. A qualified intermediary is a person or company that sells your property on your behalf, buys the replacement asset, then transfers the deed to you. 

The qualified intermediary is responsible for holding the proceeds from the 1031 exchange real estate transaction so that the sale is not taxable, handling the transition of funds from the investor exchanging like-kind properties and the seller of the replacement property, preparing the legal documents, and ensuring that the transaction is completed within IRS guidelines.

 

Tax Implications Of A 1031 Exchange

You may encounter some tax implications as a result of doing a 1031 exchange. Consider the following:

• Capital gains may occur for leftover cash, known as the “boot,” following an exchange.
• If the mortgage on the replacement property is lower than the one of the relinquished property, you may get taxed on the difference.
• You’ll get taxed for the sale of the relinquished property if the sale is unsuccessful.
• If you enact many 1031 exchanges over the years, these can yield deferred gains numbering in the hundreds or thousands, increasing your tax liability.

 

Conclusion

1031 exchanges pose some restrictions on the type of property that qualifies for a 1031 exchange. 1031 Exchanges require that the replacement investment is of “like-kind” to the investment being sold. As long as the property is being used for commercial or investment purposes, it qualifies as “like-kind.” You’ll need a qualified intermediary to help facilitate the 1031 exchange on your behalf.

 

As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.