What is a 1031 Exchange? A Beginner’s Guide
If you are involved in commercial real estate, whether as a buyer, seller or investor, you want to know what a 1031 exchange is.
The 1031 tax-deferred exchange is a procedure that lets the owner of an investment property to sell it and buy another that is ‘like-kind’ and defer on the capital gain tax of the sale.
In this post, we will cover everything you need to know about the 1031 exchange. You will learn the rules, what allows you to qualify and how to get started on the process.
What is a 1031 Exchange?
When real estate investors refer to a 1031 Exchange, they are using colloquial language to refer to Section 1031 of the United States Internal Revenue Code. This is where we can find the definitions for the conditions for tax deferral on the sale of real estate. The specific part of the tax code that we are looking at goes:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
In simple language, this means that taxes can be deferred on the profitable sale of a commercial property. To meet the requirement of a tax referral, the proceeds from the sale must be “exchanged” into a new property of “like-kind” that is held for investment purposes.
This tax deferral is used to give investors a powerful tax benefit that helps incentivize continued real estate investment. However, to take advantage of the tax benefit, the correct type of exchange has to take place and the transaction must run perfectly.
How Does a 1031 Exchange Work?
1031 Exchanges come in four common forms. One is the most commonly used and the other three can be used in specific circumstances. All of the four forms of the 1031 exchange benefit from the same tax deferral incentive. However, the qualifications for each one vary slightly. The complicated nature of these exchanges means that it is always best to consult a qualified attorney or CPA before entering into a 1031 exchange.
The four types of 1031 exchange are:
This is the most common type of 1031 exchange. It happens when an investor sells their property and uses the proceeds to purchase a new investment property. The Delayed exchange rules require that the new investment property must be identified within 45 days of the sale and the deal must be closed within 180 days.
A Simultaneous Exchange works how the name suggests. The sale of the investor’s property and the purchase of the new property are closed at the same time.
To execute a Simultaneous Exchange a high degree of precision is required. Any delays may result in the nullification of the 1031 exchange and mean that the investor then has to pay full taxes to the sale.
A Reverse Exchange also works how the name suggests. In a Reverse Exchange, the new investment property is purchased first and then the other property is sold.
In a Reverse Exchange, the new property must be purchased in cash and the relinquished property has to be identified within 45 days and sold within 180 days.
In a Construction Exchange, the investor sells their property. The new investment is then identified and put in the hands of a third-party known as a Qualified Intermediary (QI).
The investor can use the proceeds from the sale for renovations on the new property while it is in the QIs’ hands. Once renovations are complete, the investor takes possession of the property.
However, there are two conditions
- It must be “substantially the same” as it was before the renovations
- The construction must be completed within 180 days of the relinquished property’s sale date.
Whichever type of 1031 exchange is used, the process and completion can become complicated. There are specific requirements that investors must meet for each type of 1031 exchange, and if they are not met, you will lose eligibility for a full tax deferral.
1031 Exchange Rules
Above, we only scratched the surface with the requirements to qualify for a 1031 exchange. There are a series of complicated rules that you have to follow to successfully execute a 1031 exchange. These rules can be intimidating and confusing. There are many that you have to be aware of, however there are six that should be thoughtfully considered before executing a 1031 exchange.
The Replacement Property Must Be Like-Kind
We talked above about how you must purchase a “like-kind” replacement property. But what makes a property like-kind? To be like-kind, your new investment property must be “of the same nature or character” as the property you are selling. Another requirement is that the new property you purchase must be in the United States and “held for productive use in a trade or business or for investment.”
Property Must Be Held For Sale
The language used within the rules of the 1031 exchange states that there is an exclusion for a property that is “held primarily for sale.”
While what “held primarily for sale” means is not explicitly defined, generally, it is accepted that a new property should be kept for 12-24 months to show that it was purchased for the purpose of investment.
1031 Exchange Timeline
The timelines for 1031 exchanges are very specific and relatively tight. The timeline for the most common type of 1031 exchange starts when an investor’s property is sold. At the date of the sale, investors then have 45 days to identify a new replacement property and only 180 days to close the deal to be fully eligible for tax deferral.
The value of the property also must be taken into consideration. To qualify, the IRS states that the value and equity of the new property must be the same as, or greater than, the value of property that has been sold.
Boot refers to any non-like-kind property. This could be in the form of cash, installment notes, debt relief, or personal property and is valued at “fair market value.” Being “Boot” doesn’t disqualify the 1031 exchange, however, it does create a taxable event. A non-like kind property that is used in a 1031 Exchange is taxed as if it is a realizable gain.
Some investors have found that they have received boot unintentionally.
To avoid this happening in your 1031 exchange, some best practices to follow include:
- Purchase a like-kind property that has an equal or greater value than the property you sell
- Reinvest all of the equity from the sale of your property into your new property
- Obtain debt equal to or greater than what was paid off on your new property.
For a 1031 exchange to go through, the taxpayer/titleholder of the sold property must be the same as the taxpayer/titleholder on the new property.
How to do a 1031 Exchange
1031 Exchanges are complicated transactions. A lot of paperwork is required and tight deadlines mean that trying to execute a 1031 exchange can become somewhat chaotic and stressful. There is always the worry that if deadlines are not met, or if the rules are not followed correctly the exchange can be nullified and the capital gains tax must then be paid on the property.
To avoid a 1031 exchange gone wrong, there are a few best practices you should follow.
Always use an expert
When trying to execute a complicated transaction like a 1031 exchange, it is always best practice to hire the services of a professional. By having a CPA or qualified attorney, you ensure that your transaction will run smoothly and remove the chance of your paperwork being filed incorrectly.
Timing is everything
1031 exchanges have tight deadlines. Your new property must be identified within 45 days and closed in 180 days.
Finding a property, making an accepted offer, and closing within 180 days is stressful. Start your property hunt early and work with a knowledgeable broker. An experienced broker will help you move along your transaction quickly when you identify your new property.
To Sum Up
A 1031 exchange is a great incentive to reinvest in commercial real estate. Being able to defer on capital gains tax can save you a huge payout if you are looking to sell one of your current commercial properties but use the money to invest in a new one.
However, 1031 exchanges are often misunderstood. They are time-sensitive and you have to follow the rules to a T to make sure the transaction runs smoothly and you don’t end up with a nullified transaction and having to pay the taxes. Because of this, it is always best to seek expert help in the form of an attorney or CPA to help you complete a 1031 exchange.