If you’re a real estate investor, 1031 exchanges can be a great way to increase your tax efficiency. They allow you to defer the capital gains tax on the sale of real estate by reinvesting it in property similar or related in service or use. While 1031 exchanges can be beneficial to many investors and business owners, there are a lot of rules and restrictions that come with them. This article will go over what 1031 exchanges are, how they work, and general strategies to help facilitate one successfully.
What is the 1031 exchange?
In a 1031 exchange, you defer the capital gains tax by reinvesting in property similar or related to what you sold. This can be applied exclusively to real estate assets. The 1031 Exchange was enacted into law in 1921 under Section 1031 of the Internal Revenue Code (IRC). It was a limited provision at the time, but Congress has been expanding 1031 exchanges over the last 100 years. In the recent tax reform legislation passed in December 2017, 1031 exchanges are now allowed only on real estate property, and needs to be an, “Exchange of real property held for productive use or investment.”.
Three rules to follow
The 1031 exchange can be a powerful tool for deferring taxes and increasing wealth, which is why the IRS closely monitors 1031 exchanges. There are specific rules to follow to ensure you do not get penalized by the government.
First, the replacement property should be of equal or greater value to the one being sold. Second, the properties being exchanged must be considered like-kind in the eyes of the IRS. This disqualifies, for example, anyone who trades real estate for equipment.
Each 1031 exchange must also proceed within specific time frames for tax purposes. The first timeframe is the identification period, which starts on the date of the sale and ends 45 days later. During this time, you must identify what property you want to purchase.
The second time frame is the reinvestment period. This begins on the last day of the identification period and ends 180 days later. During this time, you must purchase the replacement property before the end date, or else it will not qualify for 1031 exchange status.
The final time frame is the deferral period, which starts when you purchase the replacement property and ends a year and a day later. If you sell this property as part of another 1031 exchange within the deferral period, you may be liable to pay capital gains tax on the exchanged property along with an additional 10% penalty.
How to do a 1031 exchange
Each 1031 exchange must proceed with the involvement of a “qualified intermediary.” A qualified intermediary holds legal title to the property being sold, but only temporarily. They do not have any rights or interest in it other than holding it as a custodian on your behalf. A 1031 exchange is a three-party transaction between the seller, the qualified intermediary, and the buyer of the replacement property.
1031 exchange strategies
Here are some 1031 exchange strategies to help you out.
- Identify what you want to purchase as early as possible. This gives you sufficient time to find a replacement property before the reinvestment period.
- Make the replacement property a part of your portfolio strategy. This ensures that you hold it for at least a year and avoid the temptation of trading properties frequently. The longer the time elapsed between 1031 exchanges, the better.
- Try trading properties with other real estate investors who engage in 1031 exchange. This is particularly advantageous if you fail to find a 1031 exchanged property or if your 1031 exchange fails to go through due to issues such as lack of time.
- Seek help from an experienced 1031 exchange facilitator. A 1031 exchange facilitator makes sure everything goes smoothly and the transaction is compliant with 1031 regulations. You can take advantage of 1031 exchanging services offered by your real estate agent, lawyer, CPA, and other related professionals that you work with to ensure compliance.
The 1031 exchange is a powerful tool that you can use to defer taxes on real estate sales while increasing your wealth. However, it can be incredibly tricky to handle due to the complex and rule-laden process it entails. Therefore, it is advisable to work with a professional to ensure that the IRS will recognize your transaction.
