Breaking Down The 1031 Exchange & What It Means For Investors

Key Takeaways

  • A 1031 exchange offers investors the ability to offset the capital gains tax in the event certain criteria are met.
  • The 1031 exchange has become synonymous with some of the greatest benefits of real estate investing.
  • More investors could stand to benefit from the 1031 exchange if they just knew a little more about it.

The 1031 exchange has become synonymous with some of the greatest benefits of real estate investing. At the very least, a properly executed 1031 exchange can save you an incredible amount on taxes; at its pinnacle, however, it can accelerate the ascent of your investing career. The 1031 exchange is nothing less than a complete game-changer for anyone that is aware of its existence, but I digress. It is a sad truth, but a reality, nonetheless: far too many investors and homeowners are unaware of the 1031 exchange. That, or they are less than familiar with how 1031 exchanges work.

To give your investing business the best odds of realizing success, I suggest familiarizing yourself with the ins-and-outs of the 1031 exchange; it may be the one thing you need to take your career to the next level.

What Is A 1031 Exchange?

Otherwise referred to by the Internal Revenue Service (I.R.S.) as Section 1031 under the Internal Revenue Code, a 1031 exchange awards qualifying homeowners the ability to postpone paying a significant amount of taxes in the event they sell said property for a gain. It is worth noting, however, that the postponement may only be granted if certain criteria are met; namely, if the proceeds from the sale are reinvested into a “similar” property. Or, as the I.R.S. so eloquently puts it, “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.” In other words, a 1031 exchange offers investors the ability to offset the capital gains tax — provided both of their transactions meet the criteria set forth by the I.R.S.

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What is a 1031 exchange?

Who Can Take Advantage Of A 1031 Exchange?

To qualify and partake in a 1031 exchange, you must be the owner of an investment or business property. More specifically, however, “Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031,” according to the I.R.S.

In addition to being the owner of an investment or business property, there are other details to take into consideration. For starters, not every investment property qualifies as a viable 1031 exchange candidate. To qualify, the investment property must have been held to generate passive income, not unlike your typical rental property. Rehabs, on the other hand, do not qualify, as — by definition — they are held for capital gain (not passive income). Moreover, each property involved in the exchange must be owned by the same person. That means an investor can’t sell a rental property under their own name and buy a similar property under their limited liability company (LLC).

I want to make it abundantly clear, the property must have been used as an investment to earn passive income. That means property used for personal use, like your primary home, will not qualify under the standards of a 1031 exchange.

For a better idea of what qualifies a transaction to partake in a 1031 exchange, consult the rules and regulations laid out by the I.R.S. in the Internal Revenue Code. The information contained in this article is in no way intended to be used as tax advice, and is therefore a brief overview of what to expect.

1031 Exchange Rules

Despite the relative complexity of a Section 1031 transaction, 1031 exchange rules can be broken down into seven simple tenets:

  • Like-Kind Property: In order to qualify for a 1031 exchange, the property you buy after selling your original property must be similar, or like-kind. According to the I.R.S., like-kind suggests the two properties are “the same nature or character, even if they differ in grade or quality.”

  • Investment Or Business Property: In order to qualify for a 1031 exchange, the property you sell must have been used for business or as an investment to generate passive income. That means a primary residence is not eligible.

  • Greater Or Equal Value: In order to defer 100% of the tax, the value of the property you intend to purchase in the exchange must be greater or equal in value to the property you sold.

  • Beware The “Boot”: If the new property is less valuable than the original, you can carry out a partial 1031 exchange, but the exchange won’t be 100% tax free. The difference in value, otherwise known as the “boot,” will represent the amount the buyer will pay capital gains on.

  • Same Owner: Each property involved in the exchange must be owned by the same person. That means an investor can’t sell a rental property under their own name and by a similar property under their LLC.

  • 45 Day ID Window: The seller has 45 days to identify a new property they intend to conduct the exchange with. In addition, they must notify the proper authorities.

  • 180 Purchase Window: The replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property. That, or before the due date of the income tax return for the same tax year the original property (the first property in the exchange) was sold, whichever comes first.

1031 Exchange Examples

The ambiguous nature of a like-kind property has continued to confuse investors for quite some time. To help clear things up, here are a few 1031 exchange examples:

  • It is possible to exchange an apartment building for a duplex.
  • It is possible to exchange a single-family rental that has produced passive income for a commercial building.
  • It is possible to exchange a rental property for another rental property.

To be clear, most properties will be like-kind to other properties — with a few exceptions, of course.

What Is A 1031 Like-Kind Exchange?

As I already alluded to, qualifying investment or business property owners must reinvest the proceeds from the original sale into a similar property in order to qualify for a 1031 exchange. Having said that, “like-kind” and “similar” have become synonymous with one another, at least as they are referenced in Section 1031. In other words, a 1031 like-kind exchange refers to when an investor sells a rental property and uses the proceeds to buy a similar property, which begs the question: What exactly is a like-kind property? How similar (or different) can properties be to qualify for such an exchange?

According to the I.R.S., like-kind properties are just that: of like-kind. Properties qualify for a 1031 like-kind exchange “if they are of the same nature or character, even if they differ in grade or quality.”

Under the rules specified by Section 1031, most properties will be like-kind to other properties. Of course, there are exceptions. Property in the United States, for example, is not considered like-kind to property in other countries. For more information on what’s considered like-kind (and what’s not), please consult a tax professional. Only tax professionals well-versed in Section 1031 of the Internal Revenue Code will be able to confirm whether or not two properties are of like-kind.

1031 exchange rules

What Is A Reverse 1031 Exchange?

Otherwise known as a forward exchange, a reverse 1031 exchange is “when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property,” according to RealWealth Network. In other words, a reverse 1031 exchange is exactly what its name suggests: the investor will buy first and pay later.

1031 Exchange Timeline

In order to qualify for a 1031 exchange and postpone taxable gains, each transaction associated with the exchange must take place within a certain amount of time. That’s not to say the exchange needs to happen simultaneously, but rather that the I.R.S. has put a limit on the amount of time that may pass from when you sell your first investment property to when you buy the second one. Perhaps even more importantly, investors are going to be held to two specific time limits, neither of which may be extended.

The first time limit investors need to pay special considerations to: the amount of time they have to identify a replacement. According to the I.R.S., investors must identify a replacement property within 45 days of relinquishing control of their first property. That said, identifying a replacement candidate is a little more involved than simply finding a home; you actually need to submit something in writing declaring your interest. The identification must be in writing, signed by both the individual interested in the 1031 exchange and the seller of the replacement property. In addition to a signature, the written document must include a “legal description, street address or distinguishable name.” It is worth noting that you can’t simply give notice to your attorney, real estate agent, accountant or anyone else representing your side of a deal.

Provided the investor has identified a suitable replacement within 45 days, there’s only one more time limit to abide by: the amount of time it will take to close on the subsequent property. To be clear, the next property must be “received and the exchange completed” within 180 days of the first home’s sale, “or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier,” according to the I.R.S.

1031 Exchange Calculator

Do not attempt to calculate the basis in the new property without a tax representative that is well-versed in Section 1031 guidelines. The process is complicated, as gains are merely deferred, and not forgiven. As a result, always hire a professional to make sure you proceed accordingly.

Have you ever wondered how to sell a home without worrying about capital gains? Did you even know the 1031 exchange existed? Better yet, did you know it existed, but weren’t exactly sure what it was? Let us know how you feel about Section 1031 in the comments below.

*The information contained herein was pulled from third party sites. Although this information was found from sources believed to be reliable, FortuneBuilders Inc. makes no representations, warranties, or guarantees, either express or implied, as to whether the information presented is accurate, reliable, or current. Any reliance on this information is at your own risk. All information presented should be independently verified. FortuneBuilders Inc. assumes no liability for any damages whatsoever, including any direct, indirect, punitive, exemplary, incidental, special, or consequential damages arising out of or in any way connected with your use of the information presented.

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