One of the biggest benefits to real estate investing is the tax benefit.
Not only do you get to buy properties with other people’s money (banks, investors, etc.), the profit you make on those properties can be reduced through depreciation expense.
However, if you sell the property, your cost basis is now lower, and you will more than likely face an overwhelming capital gains tax bill.
A very real personal example…
One of my close friends was going through a divorce and needed cash ASAP.
She decided to sell her duplex, which she bought 10 years earlier for $90,000. She sold it for $130,000 and owed $70,000 against the property. She thought that she would walk away with about $50,000 after real estate agent commissions, fixing the property up, and selling it.
But she walked away with only about $20,000 because of the large capital gains tax.
Think about that.
Her gain was less than 50% of what she thought it would be because of taxes!
Fortunately, you can use a 1031 exchange. This tax rule lets real estate investors avoid capital gains tax if they invest the funds into another property.
There are a lot of details about qualifying for 1031 exchanges, which we will cover below.
Before we do, let me make a disclosure.
I am not a lawyer and this is not legal advice. Before doing anything with tax implications, I highly recommend you speak with a tax accountant, tax lawyer, and a title company that do 1031 exchanges.
The official definition of a 1031 exchange:
According to the IRS:
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
Rules of a 1031 Exchange
1. Time Rules
If you take away nothing else away from this article, know this:
You have 45 days to identify a new property after the sale of an existing one. You have 180 days to purchase the property with the funds received from the sale of the old property.
The 1031 exchange begins on the earliest of the following:
- the date the deed records, or
- the date possession is transferred to the buyer,
and ends on the earlier of the following:
- 180 days after it begins, or
- the date the exchanger’s tax return is due, including extensions, for the taxable year in which the relinquished property is transferred.
The identification period is the first 45 days of the exchange period. The exchange period is a maximum of 180 days. If the exchanger has multiple relinquished properties, the deadlines begin on the transfer date of the first property. These deadlines may not be extended for any reason, except for the declaration of a presidentially declared disaster.
2. Title Rule
Section 1031 requires that the taxpayer listed on the old property be the same taxpayer listed on the new property. If you are married and sell the old property, then your spouse must also be on the title to the new property.
If a trust or corporation is on the title of the old property, that same trust or corporation must be on the title of the new property.
3. Intermediary Requirement
This is one of the easiest requirements to fulfill. Unfortunately, it is one of the rules that is broken the most.
Sellers cannot have access to the money in between the sale of the old property and the purchase of the new property. The IRS states that an independent third party, known as a qualified intermediary, must be used.
The qualified intermediary must not be related to you in any way. There are strict documentation rules intermediaries must follow to comply with all the IRS guidelines.
The intermediary must hold the proceeds of the sale in a separate account until the purchase of the new property is completed. The taxpayer is entitled to the interest of these funds, and must treat the interest as ordinary income during the period of escrow.
4. Reverse Exchange
This is an extremely confusing legal issue, but it boils down to this:
You cannot own both the properties (the one you are selling and the one you are buying) at the same time.
This might seem like common sense, but it’s customary in complicated commercial transactions to have delays in financing.
This section of a 1031 transaction comes in handy when you have a property under contract to buy, but you have not yet sold your existing property. There can be a major financing problem with this, whereby the exchange requirement comes into effect.
Let’s not complicate the issue by dealing with financing. Let’s just focus on the title issues.
The IRS will let you put the property you are purchasing in an exchange entity (typically an LLC). The old property must be sold and closed within 180 days of first acquiring title to the new property. As soon as the old property is sold, the proceeds are then directed to the exchange accommodation titleholder at which time the property may be deeded out of the parking arrangement directly to the taxpayer.
5. Reinvestment Requirements
You don’t have to reinvest 100% of the proceeds into another property. You can do a partial exchange. However, you must recognize the income if there is a capital gain.
You can also designate multiple properties as replacement properties. However, the fair market value of the replacement properties cannot exceed 200% of all the exchanged properties. The IRS also performs certain valuation tests for this.
6. Like-Kind Property
The like-kind requirement states that the property being sold and the property being bought should be like-kind. This is frequently misunderstood. The purpose of this rule is to discourage professional flippers from taking advantage of the 1031 exchange to avoid capital gains tax.
The factor that seems to weigh the most is the intent of use for the property.
One of the basic premises is that your primary residence can never be used for a 1031 exchange. Additionally, if you sell to a related party, the buyer is required to hold the property.
IRS Forms for 1031 Exchanges
Publication 544: Sales and Other Dispositions of Assets
Form 8824: Like-Kind Exchanges (PDF)
Form 4797: Sales of Business Property
Alternatives to 1031 Exchanges
A negative with 1031 exchanges is the time requirement to purchase a property fast. This can lead to a bad deal. However, there is an alternative to a 1031 exchange, and you can still defer the taxes. This alternative is a structured sale.
Structured sales work well for sellers who want to create a continuing stream of income without management worries. Retiring business owners and downsizing homeowners are examples of sellers who can benefit.
Further Reading: 26 U.S. Code § 453 – Installment method
What Experts Have To Say
I interviewed several 1031 exchange experts. Below are some interesting responses when I asked:
Q. What is the one mistake you see most often with 1031 exchanges?
A. (Dave Foster, Exchange Resource Group): The number one mistake that 1031 investors make is not starting the search for their replacement property until they complete the sale of their relinquished property. While the closing of the sale must happen prior to the closing of the purchase, there is no similar requirement regarding going into contract. So the strongest course is to locate and get your new property under contract prior to the sale or immediately after rather than waiting and trying to search for a good replacement property during the 45 day identification period.
The one mistake about 1031 is actually two:
- Like-kind means that any kind of investment real estate may be exchanged under 1031 for any other kind of investment real estate. Residential to commercial, industrial to raw land, single family to multifamily. It is all considered like-kind. And the number of properties also does not matter. So it is possible to sell one and buy two or sell two and buy one.
- People think that they need only reinvest the profits from their old property, and that they can take their original capital back without paying tax. While it is true that your original capital or down payment will not be taxable, the IRS says that if you are doing a 1031 exchange and you do not purchase at least as much as you sell and use all of the proceeds in the next purchase, then the amount that you buy down or the cash you take out will be your profit first, and you will not take out your original capital until the last. So while a dollar is a dollar, and you can argue that you are taking out nontaxable original capital, the IRS says you are taking out profit. And since they have nuclear weapons and you don’t, they win the argument.
A. (Bill Exeter, Exeter 1031 Exchange Services, LLC): I think the one mistake that investors make the most often is not seeking the advice of their legal, tax, and financial advisors – and a good qualified intermediary – before they structure their 1031 exchange transaction. The challenge is that investors do not know what they do not know, and therefore do not know when they have a potential problem with their 1031 exchange transaction.
Potential problems can almost always be fixed if caught before the investor closes on any of their transactions, but usually become permanent once a transaction closes. Consulting with their legal, tax, and financial advisors can save people thousands of dollars in income taxes.
A. (Ron Webster, Florida real estate attorney): Two points … misunderstandings and mistakes:
The most common misunderstanding is that folks fail to recognize that when they sell property they MUST acquire another property for equal or greater value. Too often, people mistakenly believe that they only need to reinvest the amount of gain. This does not qualify for 1031 exchange treatment.
The most common mistake is that people do not recognize the need for a formal 1031 exchange agreement and exchange partner to hold the funds. They receive funds at closing, mistakenly believing they can still do an exchange. Once funds are disbursed, the toothpaste is already outside the tube and cannot be put back in. Funds can never, ever touch the hands of the seller, as they must always be held by the intermediary and used to purchase the replacement property and be outside the control of the seller.
8 Steps to Accomplishing a 1031 Exchange
- Retain an attorney/CPA.
- Sell the property. Include a cooperation agreement where buyer is aware of seller’s intention of a 1031 exchange.
- Enter into a 1031 exchange agreement with your qualified intermediary.
- The relinquished escrow closes, and the funds are placed in a separate account.
- Notify the qualified intermediary within 45 days of finding a property you are intending to buy with respective funds.
- When all conditions are satisfied, prepared to close within 180 days of the previous sale.
- Taxpayer files form 8824 with the IRS when taxes are filed.
Now you should have a clear understanding of what a 1031 exchange is and how it can benefit you and your real estate investing.
It’s highly recommend that you consult a tax accountant and an attorney who have experience with 1031 exchanges.
- Like-Kind Exchanges Under IRC Code Section 1031 (IRS)
- 10 Things To Know About 1031 Exchanges (Forbes)
- History of the 1031 Exchange (Exeter)
- Pro’s and Con’s of 1031 Exchanges (Huffington Post)