What is a 1031 Exchange and Why is it One of The Most Powerful Tools in Real Estate Investing?
This article is part of our passive investors guide on real estate syndications, available here.
When it comes to real estate investing, most people have at some point heard of a 1031 exchange and its majestic powers! For individual investors, the 1031 exchange is a great tool to encourage and promote ongoing improvements; it also helps drive markets.
They create a sustained transaction volume in the real estate market and, as a result, create a secondary business economy to facilitate those transactions and renovations that need to be performed. In this guide, we’ll go in-depth on what a 1031 exchange is, the qualifications, how it works in real estate investing, some examples, and much more.
How does a 1031 exchange work in real estate? - (Capital Gains Tax Deferral For Your Investment Property)
In 1921 the U.S. Internal Revenue Service passed a statute to help incentivize ongoing re-investment into a property on U.S. soil by offering deferred taxation on these ongoing investments. Under Section 1031 of the Internal Revenue Services tax code, 1031 Exchanges, also referred to as “like-kind” exchanges, are a tax advantage vehicle for real estate investors.
Enabling an investor to defer the capital gain taxes on their real estate investments and trade up to more significant assets, with the ability to defer these taxes forever. When the individual who owns this real estate passes on, their beneficiary inherits the investment property and, essentially without going into further detail, avoids decades of deferred taxes of all the bought and sold real estate in that exchange.
But as of 2021, President Biden is looking to change the internal revenue code and close the book on 1031 exchanges as a part of his controversial tax plan that would also increase the capital gain tax percentage and would mean an end to the ability to defer capital gains tax.
1031 Exchange Qualifications
To qualify for a 1031 exchange, you must meet the following conditions.
- New property of equal or greater value than the property that is being sold
- Both properties must be like-kind
- The replacement property must be identified within 45 days
- The replacement property must be purchased within 180 days
1031 Exchange Restrictions
There are a few major restrictions to consider, and they are as follows.
- If you exchange for a cheaper valued property, you’ll still have to pay the capital gains tax on the difference.
- You can’t perform a 1031 exchange on personal property, only on investment property.
What is the purpose of a 1031 exchange?
The purpose of a 1031 exchange is for savvy real estate investors to rapidly grow their portfolios and grow their net worth faster and more efficiently than ordinarily possible. Deering taxes on the gains from the sale of property and then rolling into a more considerable or like-kind asset is truly a game-changer.
1031 exchange timeline
The 1031 exchange timeline is a rigorous process and puts a real estate investor’s feet to the fire to identify a fair market value property in the allotted time. The two main time components to performing a successful 1031 exchange are first, the 45 days from the date you sold your property to identify several properties to exchange with it, and second, to have the exchange closed within 180 after the sale of the exchanged property.
- 45 Days: You must identify the properties that you may potentially exchange via a signed letter in writing. The qualified intermediary, who will be overlooking the exchange, will receive this letter.
- 180 Days: The closing 180 days after your exchanged property sells presents the biggest hurdle for real estate investors. If the exchange fails to take place on time, the exchange will not qualify, and as a result, you will have to pay the capital gains tax. Although 180 days is quite some time to close a deal, sometimes the negotiation may not go as planned, and there may be re-trades on pricing that slow down the closing.
1031 exchange examples
Let’s say you purchased a multifamily property for $800,000 and put in about $200,000 in capital improvements so you have a cost basis of $1,000,000. After 5 years let’s say the building is worth $2,000,000 and if you were to sell it, you would have about $1,000,000 in profit.
The capital gains tax would be 20% on that $1,000,000, so you would pay taxes of $200,000 to uncle sam. In an effort to defer the taxes and have a higher purchasing power by being able to roll over all of your profits into the next deal, we can elect to 1031 exchange the property for a “like-kind” property. That means that instead of only reinvesting the net $800,000 ($1,000,000 profit – $200,000 capital gains taxes) after-tax profit, I can instead roll over and exchange the full $1,000,000.
Exchanging the $1,000,000 as opposed to the $800,000, allows me to buy a larger valued property, in this case, I would have to identify another multifamily property that’s at least $2,000,000 or more in value within 45 days. I would then have to close on one of the identified properties within 180 days, through a qualified intermediary. If you don’t meet this criterion, and within the allotted timelines, you will have failed to meet the guidelines for the exchange, and would now owe the $200,000 in capital gains taxes.
Related Read: Do I Qualify for Real Estate Professional Status?
How are mortgages on the relinquished property treated?
A portion of proceeds used to pay a mortgage or act of trust is recognized as realized proceeds. When buying this replacement property, the mortgage is to be replaced by a new mortgage or cash.
Taxpayers can never take an outstanding note in return for the sale price incurred by the receiver’s estate without acknowledging its gain. A note is treated as a substitute property, not a replacement property, so a taxpayer can’t take that note back without recognizing its profits. A mortgage is not repaid from exchange funds unless secured by a mortgage or trust on the relinquished property. The taxpayer has to replace the mortgage with cash or replace the mortgage.
Build to suit or improvement 1031 Exchange
Improvements on land that the taxpayer purchased will not count as substitute property under a 1031 exchange. By implementing build-to-suit, improvement exchanges, or construction exchanges, taxpayers would be able to receive property that has been improved to their specific specifications.
Exchange-derived cash may be used for upgrades through a request for the draw submitted by the taxpayer to the qualified intermediary and the taxpayer. In an unrestricted transaction, the improved replacement property is transferred to the exchange accommodation titleholder within 90 days after the abandonment of the property.
Held for business or investment purposes
The reallocated and substituted land must be held for business or investment purposes. The exchange involves many different kinds of property. Agricultural commodities like land and farm can be exchanged. Property used primarily as a private residence may be considered inexorably less advantageous in exchange for similar items. A sale of business property does not have to be replaced by other business-related property, but investment assets can replace it. It must be used in trade or investment.
Frequently Asked Questions About The 1031 Exchange Timeline
The IRS says you should hold a recently 1031 exchanged property for at least two years. However, there is literature that points to a minimum of 1 year. It’s important to note that each exchange is very different, but ultimately, the investor must prove, if challenged, that the property was held for investment purposes and resell.
A 1031 exchange may not be the best option for you for several reasons. You may not want 1031 if you want to take a lot of capital off the table when you sell your property, as you’ll be rolling over your profits into the next property. Also, it may not make sense for you if you think you won’t be able to find a suitable replacement property. This may force you to overpay for the asset you’re rolling into to avoid disqualifying the exchange.
If you’re looking to defer all the capital gains taxes from the sale of your property, you would want to reinvest 100% of the sale proceeds. This ensures that you take full advantage of what the 1031 exchange offers, allowing you to reinvest your pre-tax gains and grow your portfolio.
What is the purpose of a 1031 exchange - Conclusion
There are countless success stories of real estate investors who started from nothing and utilized the 1031 exchange for trading up into greater-value properties. These same investors, throughout their lifetime, we’re able to create an abundance of wealth for themselves and their families. 1031 exchanges are a necessary tool to create a sustained level of transaction volume in real estate. The media, including President Biden, who is looking to end 1031 exchanges, is trying to run the narrative that they enable the rich to get richer, but this couldn’t be farther from the truth.
1031 exchanges account for a good percentage of all real estate transactions in a given year. If the 1031 exchange is removed as a tool for real estate investors, they’ll hold onto their properties for life to skip out on selling and paying the capital gains tax. In this scenario, the government won’t likely collect more tax revenue as they may hope.
More transactions mean more secondary business is done to facilitate those transactions, such as using other service providers like real estate brokers, title companies, lawyers, mortgage brokers, and much more. It also encourages real estate investors to invest more capital into their properties to increase the property’s valuation, sell it, exchange the property, and do it all over again. When real estate investors do this, it creates competition.
By increasing capital improvements into an apartment unit, for example, the residents benefit from a better product and quality of living. Resulting in more business, pushing them to hire more blue-collar workers to meet that demand. Someone has to perform all these capital improvements, and that’s where the contractors come into the picture.
So you see, 1031 exchanges help drive local economies and are a necessary tool to help promote ongoing improvements. Let’s hope it’s here to stay!
- Investopedia, “What Is a 1031 Exchange? Know the Rules“
- IRS.GOV “Like-Kind Exchanges – Real Estate Tax Tips“
- Forbes “1031 Exchange: Deal or No Deal“
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