Some of the country’s richest people got their start by investing in real estate, reinvesting their profits and growing an empire. And one tool that makes this possible is the 1031 exchange, which is named after Section 1031 of the Internal Revenue Code. But this tax-saving tactic isn’t just for the wealthy.
“One common misconception is that 1031 exchanges are only for large-scale investors with high-value properties,” says Josh Katz, certified public accountant and founder of Universal Tax Professionals.
“In reality, 1031 exchanges can benefit any investor looking to defer capital gains taxes on investment properties, regardless of the property’s value.”
What Is a 1031 Exchange?
A 1031 exchange, also called a like-kind or Starker exchange, is a handy tactic for people who invest in real estate. It lets them sell property they own and replace it with similar property without taking taxes off the top. This method is popular because it helps real estate investors upgrade their portfolios and defer taxes on their profits. To work a 1031 exchange, you have to spend some money, follow a few rules and hop through some hoops, but it may be well worth the effort.
How Does a 1031 Exchange Work?
You may qualify to defer gains when you sell investment real estate by replacing the property with a similar one and following a few rules. This allows you to keep and reinvest more of your profits.
Before attempting a 1031 exchange, make sure that:
— You want to sell an investment property and expect to have a large, taxable gain.
— You plan to replace that property with more investment real estate.
— You’re committed to real estate investing for the foreseeable future and won’t need to cash out soon.
“A 1031 exchange may not be suitable for investors who need immediate liquidity or those who are uncertain about reinvesting in real estate,” says Katz.
“If you need quick access to cash from the sale, a 1031 exchange could limit your financial flexibility. If you face significant life changes, such as retirement or a need to diversify your investments, a 1031 exchange might not align with your financial goals.”
Requirements for a 1031 Exchange
And now, here are the rules.
— You must commit to the exchange before selling your property. That’s because once you take possession of the proceeds, any gain on the sale becomes taxable.
— The property you already own and that you plan to sell is called the “relinquished property.” The property that you plan to purchase is called the “replacement property.”
— Because you’re not allowed to control the proceeds of the sale, you have to hire a third party to manage the sale and hold the proceeds. This person or company is called a qualified intermediary, or QI.
— You must replace the real estate you sell with “like-kind” other real estate. So you could sell a single-family home and buy an apartment building or raw land, for instance.
— The replacement property must be of equal or greater value than the relinquished property.
— The property must be held for investment or used in a business. Your personal residence or vacation home won’t usually qualify.
— The transaction must be at “arm’s length,” which means you can’t buy from or sell to a family member or anyone with whom you have a close personal relationship.
Types of 1031 Exchange
There are several ways to pull off a 1031 exchange. All of them require you to work with a QI, but the timing of the purchase and sale differ.
“One of the most common misconceptions that I see people have about 1031 exchanges is that the selling of one property and buying of another has to happen simultaneously, or in a single transaction,” says Seamus Nally, CEO of TurboTenant.
“Luckily, this isn’t the case — it would be very hard to accomplish. Instead, you actually have 180 (days) after selling your property to purchase the replacement property, providing a lot more wiggle room.”
Simultaneous 1031 Exchange
With a simultaneous exchange, you close on the sale of the relinquished property and the purchase of the replacement property at the same time. The simultaneous exchange may require a lot of coordination between you and other buyers and sellers. It can also be a straight swap in which you just trade real estate with someone.
Delayed 1031 Exchange
With a delayed exchange, you first sell your property and have the QI hold the proceeds until you find a replacement property. You have 45 days from the day you close on the relinquished property to identify one or more replacement properties and up to 180 days (total) to complete the purchase.
This is the most common 1031 exchange. The advantage of a delayed exchange is that selling first gives you money to work with when buying the replacement. In addition, there may be less pressure when you have 180 days to buy than when you have to sell.
Reverse 1031 Exchange
The reverse 1031 exchange works like the delayed exchange, but you buy the replacement property first. Then, you have 45 days to identify the relinquished property and 180 days (total) to close on the sale.
“The reverse exchange is generally considered the hardest because it requires purchasing the replacement property before selling the original one, demanding significant liquidity,” Katz says.
Construction/Improvement 1031 Exchange
You can use the proceeds from a relinquished property to build or renovate a new property. The construction/improvement exchange works with any timing — simultaneous, delayed or reverse. However, the property must be purchased as part of the exchange. You can’t already own it or buy it outside the 1031 exchange.
Pros and Cons of a 1031 Exchange
While 1031 exchanges can save you a lot of taxes, they’re not right for everyone. Here are the pros and cons.
How to Do a 1031 Exchange
The most common 1031 process goes like this:
1. Identify the property you want to relinquish and estimate the expected gain.
2. Hire a QI. The QI cannot be your real estate agent or broker, investment banker or broker, accountant, attorney, employee, or anyone who has worked for you in those capacities within the previous two years.
3. List your property for sale and make sure the agent and title officer understand that you’ll be doing a 1031 exchange. Have them work with your QI to make sure that the proceeds never touch your accounts.
4. You have 45 days from the sale date to identify either up to three replacement properties of any value, or multiple properties with a total value not exceeding 200% of the relinquished property’s value.
5. Purchase the replacement property and close within 180 days of the sale date for the relinquished property.
6. File Form 8824 with your taxes the next year.
[Read: Best Mortgage Refinance Lenders.]
Mortgages for a 1031 Exchange
You can take out almost any type of investment property mortgage
for the replacement property. But there are a few considerations.
The loan on your replacement property must be at least as large as the mortgage balance of the relinquished property. This shouldn’t be an issue unless you’re concerned about qualifying for a mortgage. Perhaps because interest rates have risen, your credit rating has dropped or you have more than 10 financed properties.
In that case, it’s critical that you get mortgage preapproval before listing your property. Or you might want to pay off or pay down the existing mortgage on the relinquished property before listing it for sale.
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The 1031 Exchange Isn’t Just for Rich People originally appeared on usnews.com
