What to Know About a 1031 Exchange
So, what exactly is a 1031 exchange?
Think of a 1031 exchange as a way to keep your money working for you as opposed to using that money to pay the government taxes. As the famous quote by Benjamin Franklin says, "In this world, nothing is certain except death and taxes," but thankfully, there are loopholes such as the 1031 exchange that allow for huge savings opportunities!
A 1031 exchange, also known as a like-kind exchange or a Starker exchange, is simply a way to defer payment on capital gains taxes that are triggered by the sale of a rental or business property. It is named after Chapter 1031 of the Internal Revenue Code (IRC) and most commonly involves the sale of rental, vacation, or investment property, but can also be used for the sale of personal property such as a plane, boat, livestock, etc. This exchange only works if you plan to re-invest all capital gains into another like-kind investment. This article explains the requirements and important information you need to know about 1031 exchanges.
What is Capital Gains Tax?
To fully understand how a 1031 exchange works, it is important to know what capital gains tax is. The profit you make on the sale of your property is considered capital gains and just as the government wants a cut of your income, it also expects a cut of any profit (capital gain) that you make on the sale of your properties. Let’s say you made $100,000 profit on the sale of a rental property, in which you would incur $30,000 in capital gains taxes. Your profit now goes from $100,000 down to $70,000. However, if you complete a 1031 exchange and roll 100% of your proceeds into a similar property of equal or more value, you can utilize all your profits and afford a larger investment than what you could afford after paying capital gains tax.
How to Qualify for a 1031 Exchange?
1. Replacement Property Must Be of Like-Kind to the Property Sold
To qualify for a 1031 exchange, the property sold and the property to replace it, must be of like-kind. This means, that they need to be similar in purpose but do not have to be identical. For example, if you sell a rental property, you can replace that with any other type of real estate as long as it’s not intended for personal use. You can re-invest in land, an office building, another residential rental home, etc.
Often times, investors misunderstand this requirement thinking that they have to re-invest in a property that is identical to the property sold. For example, re-investing in vacant land because the property sold was vacant land. It is beneficial to remember that the two properties only need to be alike in their purpose to avoid possible rejection from the IRS.
2. House Flips Don’t Typically Qualify
Investments that are intended to be long-term are typically required. This means that short-term investments such as property flips are not recommended for a 1031 exchange, as the IRS considers properties acquired in this way to be inventory rather than investments.
There are a couple of steps you can take that may make it possible to qualify a short-term investment for a 1031 exchange:
• Make the property income producing so that it is recognized as a business investment.
• Own the property for at least a year and a day to reach the long-term capital gains tax rate.
Keep in mind, that implementing the above steps does not guarantee qualification for these types of short-term investments. Further qualifying factors may be necessary and speaking with a CPA with experience in 1031 exchanges is advised.
3. The 180-Day Rule
Once you have closed on the sold property, you have 45 days to identify a replacement property and the exchange must be completed within 180 days from the closing of the original property. There are absolutely no exceptions to either of these timeframes. If either are missed, your exchange will not be successful.
4. The Use of a Qualified Third Party
There must be a qualified third party who holds the profit (capital gain) from the sale of the original property until they are reinvested in the replacement property. In fact, if at any point your proceeds come into your possession between the sale of your property and the acquisition of your replacement property, you run the risk of the IRS denying your exchange.
Although it is not specified as to who you are required to use as a qualified third party, the general rule of thumb is neutrality. Your designated third party cannot be anyone who has had agency or fiduciary relationship to you. Examples of people that you cannot use are:
• A member of your family
• Your lawyer
• Your real estate agent
• Your tax advisor
5. You must re-invest 100% of Proceeds
As mentioned above, in order for this exchange to work, 100% of your proceeds need to be re-invested into a replacement property of equal or greater net sales price of the property sold. For example, if you sell a property for $350,000, then you must re-invest in a property or properties that is/are equal to or greater than $350,000. If the replacement property/ies are less than the property sold, then you will only qualify for a partial exchange and any of the proceeds not used in the re-investment will be taxed.
Now that we have covered the important details of a 1031 exchange, here are a few things to keep in mind:
• Although conducting a 1031 exchange is not an easy task and hiring a professional is advised, no one trying to avoid paying capital gains tax fails if the requirements are met. This piece of valueless paperwork does the trick!
• A 1031 is a tax deferred exchange, sometimes referred to as tax free exchange, which is not accurate. The tax that is deferred is only deferred until the day the property is sold and the profits are not used to re-invest in a new property.
• Taking advantage of a 1031 exchange allows you to build your wealth faster by keeping all your money working for you instead of paying it in taxes.
I hope that after reading this article, you have grasped a better understanding of what a 1031 exchange is and how it can possibly benefit you and your future investments.