The 1031 Exchange Rules: Real estate investment can be a highly lucrative endeavour. Unfortunately, real estate investors are aware that it carries the same tax burden as the majority of other forms of investment. The 1031 exchange allows astute real estate investors to defer payment of capital gains taxes indefinitely, assuming Congress does not change the more than 100-year-old 1031 exchange rules.
The 1031 exchange, named after the section of the Internal Revenue Code that defines its numerous rules and regulations, allows an investor to defer tax payment by adhering to a series of stringent rules. Following is a list of the information you need to fully benefit from a 1031 exchange.
The 1031 Exchange Rules
1. 1031 Exchanges Are Also Referred to as ‘Like-Kind’ Exchanges, and This Is Significant.
Section 1031 of the Internal Revenue Code defines a 1031 exchange as the exchange of real property used for business or held as an investment for another property of the same type or “like-kind.” As the code makes clear, real properties are generally considered to be “like-kind,” and the seller of a business property can effectively defer the arrival of the Tax Man by reinvesting the sale proceeds in a subsequent business property. Under the 1031 rules, a seller of raw land can consider a rental property to be “like-kind,” and a seller of an apartment complex can purchase a medical building and consider it “like-kind” as well.
You are exchanging one property for another (typically referred to as a drop and swap 1031 exchange), and in doing so, the second property assumes the cost basis of the first property. The code is intended to facilitate the reinvestment of one piece of real estate into another. However, in accordance with the “like-kind” requirement, an investor cannot use the proceeds from a real estate investment to buy equities or bonds. In some instances, however, certain hydrocarbon and gas interests could be considered similar.
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2. Attention: You’re on the Clock!
When considering a 1031 exchange, the race is indeed to the expeditious or, at the very least, the efficient: You have 45 days from the date of sale of the original property to designate a new investment property. And you only have 180 days from the date of the original transaction to close on the new investment property. (Remember, that’s 180 days from the date of the original transaction, not 180 days from the date of the new property’s identification!) If you miss either of these deadlines (such as identifying the new property by day 46 or completing the new transaction by day 181), you will be responsible for capital gains taxes on the initial transaction. There are no exceptions. To assist with this, here is an excellent infographic about the typical 1031 exchange timeline that you can download for free.
3. 1031 Exchanges are ineffective for downsizing an investment.
The rigorous rules governing 1031 exchanges stipulate that the new investment property must be of equal or greater value than the sold property. In addition, for a complete tax deferral, the entire sale proceeds must be used to acquire the second property.
Therefore, if the first property sells for $250,000, you cannot reinvest $200,000 in a new property and take the $50,000 difference; the full $250,000 must be included in the second transaction. If it is not an asset of equal or greater value, the applicable capital gain will be subject to capital gains tax.
There are four distinct ways in which transactions can be structured.
- Five distinct types of 1031 exchanges are typically used by real estate investors, whose requirements vary depending on the circumstances.
- Deferred exchange, in which one property is sold and another property (or properties) are purchased within the 180-day window.
- Exchange occurring simultaneously, with both transactions occurring at the same time.
- In a delayed reverse exchange, the replacement property is acquired before the original property is sold.
- Deferred build-to-suit exchange, with the proceeds used to finance a new property constructed to meet the investor’s requirements.
4. You’re Going to Need Assistance with This.
You will need to retain the services of a 1031 facilitator or qualified intermediary (QI) to ensure compliance with the IRS’s stringent requirements. Some of the most common errors made by first-time investors attempting a 1031 exchange can be readily avoided with professional guidance. These include adherence to the crucial 45- and 180-day periods, the selection and identification of suitable properties for exchange, and the management of funds between transactions.
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Taking personal receipt of the original sale proceeds is a major no-no and will promptly trigger the capital gains tax liability, even if all other 1031 exchange rules are followed. Use a qualified intermediary to manage the funds for you. (You can locate a QI with the help of your professional team or by contacting the Federation of Exchange Accommodators, who will put you in touch with a local expert.)
5. This is a Complex Matter. Is It Valuable?
To illustrate, let’s examine an illustration. Consider the situation of Tracy, who wants to sell the $3 million apartment block she purchased for $1 million. Assuming there is no mortgage on the property, Tracy faces a 20% capital gains tax rate.
The sale is finalised at $3 million. The 20% tax on Tracy’s $2 million profit amounts to $400,000. Tracy is also subject to a net investment income tax of 3.8%, or $76,000 (since the transaction exceeds $250,000), as well as, dependent on the state in which she resides, a state capital gains tax. Only seven states have no such state tax, with rates ranging from 2.9% in North Dakota to 13.3% in California. The lowest rate is in North Dakota, at 2.9%, and the highest is in California, at 13.3%. If Tracy does not reside in a tax-free state, the decision to pay out entirely will be costly: at least $534,000 and possibly as much as $742,000 in total taxes.
6. One final ‘trick’: the only way to make tax deferrals permanent.
As stated throughout this article, the 1031 exchange is not a tax-elimination strategy, but rather a tax-deferral one. Eventually, the capital gains tax is due if you sell an investment property without reinvesting the proceeds through a 1031 exchange.
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Your investment property’s cost basis is increased to its current market value upon your demise, and your heirs can choose to sell it at that price with limited or no capital gains tax liability. It is a permanent solution to a permanent problem, but many real estate investors include it in their estate plans if they never need to liquidate their investment properties.
Daniel C. Goodwin, Provident Wealth Advisors, and AAG Capital, Inc. are not solicitors and therefore do not offer legal counsel. This article should not be interpreted as legal or tax advice. An investor should always obtain competent legal and tax advice for his or her unique circumstances and state-specific laws.
