Author: Joe Nawrot Land Specialist at UC Midwest Lifestyle Properties
Understanding 1031 Exchanges needn’t be difficult. As with any tax deferring code, you have your qualifications and principal rules. In this article, we will discuss:
- What is a 1031 Exchange?
- Benefits of a 1031 Exchange
- Types of 1031 Exchanges and their Definitions
- Rules of a 1031 Exchange
IRS TAX CODE 1031
1031 gets its name from Section 1031 of the U.S. Internal Revenue Code. There is a wonderful pdf from Accruit.com which you can print out courtesy of Cornell Law’s Legal Information Institute.
WHAT IS A 1031 EXCHANGE?
The 1031 Exchange allows you to avoid paying capital gains tax when you sell an investment property and reinvest that money in another property of equal or greater value. The IRS titles it as “like in kind” property. For example, you cannot take your valuable racehorse and do a 1031 Exchange for an apartment building- they are not “like in kind”. Your 1031 Exchange property must be within the U.S.A. as no foreign country properties may be used.
BENEFITS OF A 1031 EXCHANGE
If growing your real estate investment portfolio is a part of your wealth strategy then using 1031 Exchange gives you the ability to defer capital gains tax.
In some ways, it is like trading up. You started with property X being valued at 123 and you were able to buy property ABC with the same or greater value because properties ABC are going to give you a better return than property X. Clayton Morris has an informative YouTube video on 1031 Exchange.
TYPES OF 1031 EXCHANGES
There are four types of 1031 Exchanges. Today we will just discuss Simultaneous Exchange and the Delay Exchange.
- Simultaneous Exchange
- Delay Exchange
- Reverse Exchange
- Construction or Improvement Exchange
A simultaneous exchange is a replacement of a relinquished property with a new property. This exchange must close on the same day. This can be done as a “two-party” trade with no intermediary or a “third-party” with the professional intermediary. Since this transaction affects your income, it is highly suggested that you use a professional intermediary. A professional intermediary oversees the entire transaction, saving you any headaches with the IRS.
More common is the delay exchange. In a delay exchange the property owner relinquishes the original property before he acquires a new property for replacement. A delay exchange sounds relatively easy but know ahead of time that there are a few rules that must be followed for it to qualify. Note: You are still responsible for the marketing and sale of the property you are relinquishing.
Once you have relinquished the property you have exactly 45 days to select your next property/properties (up to 3 properties) of “like-kind”. So the pressure is on and hopefully, the real estate market is in your purchasing favor.
Having selected your property you then must close within a 180-day window from the sale of your relinquished property or within the due date of your income tax return in the year your property was relinquished- whichever date is earlier. Your professional intermediary will make sure that these rules are followed to a “t”. Giving you peace of mind and keeping you from tangling with the IRS.
RULES OF 1031 EXCHANGE
There are seven important rules to follow in a 1031 Exchange. Not adhering to the rules could find yourself paying capital gains. Let’s look at the seven rules and then define each one.
- “Like in Kind”
Both the original property and the replacement property must have the same nature regardless of grade or quality.
- Investment- Business Purposes Only
These properties are investments. You cannot use a personal residence. They must be investment properties.
- Greater or Equal Value
If you are to avoid paying capital gains tax, you will want to make sure the property you are buying has a greater market value and equity or equal to that of the property you are selling.
- Must not receive “boot”
This is an odd term. “Boot” is the difference (value) between your selling of a property and the cost of the new one. For example, if you sold your current property for 2,000,000 and bought a new property for 1,000,000 the difference is 1,000,000- which you will have to pay capital gains tax on this difference which is the “boot“.
- Must be the Same Tax Payer
Quite simply the person named on the tax return must match the person named on the title to the property. There is an exception to this such as the SMLL (single-member limited liability company).
Lastly, we have the 45 Day Window rule as well as the 180 Day Window rule which was explained above. There are many advantages to using the 1031 exchange and using a professional intermediary will give you the safety and peace of mind in growing your real estate portfolio.
Resources: