02 Apr Tax Deferral Do’s and Don’ts: Your Guide to the 1031 Exchange
It’s that time of year again – and you know what they say, the only two certainties in life are death and taxes. Taxes for real estate can be quite the migraine, but those who know how to utilize the right tools available will come out on top.
Cue: the 1031 Exchange – a tax strategy that allows investors to grow their portfolio while increasing their net worth.
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What is the 1031 Exchange?
According to the Internal Revenue Code, exchanging rental properties that are of like-kind, such as properties used for business or as business investments, may be able to defer paying taxes on capital gains. With that said, real estate investors can avoid the requirement of recognizing a gain or loss on property by utilizing a 1031 Exchange.
Remember, nothing comes free – so while you can defer taxes due, you aren’t avoiding them completely. The 1031 Exchange allows active investors to defer paying capital gains tax. In doing this, investors can hold onto their cash and reinvest capital gains to create a stronger portfolio and encourage business. (Note that this only applies to like-kind exchanges, so if the property was held primarily for sale, you’ll have to sit this one out.)
Initially created as a way to encourage reinvestment, this code allows investors to avoid being taxed on ongoing property investments – and if you’re willing to get savvy, it can save you a lot of money. But here’s the catch – if the rules aren’t followed exactly, you may be held liable to capital gains taxes.
It’s important to understand the rules and guidelines of 1031 Exchanges before the time comes to file, because they have strict timelines and often require professional assistance. While avoiding taxes on capital gains and opening the opportunity to reinvest funds may sound nice, there’s a little more to it than that.
Here’s what you can and can’t do when it comes to 1031 Exchanges.
What properties can I exchange?
The biggest must-have for properties to qualify for 1031 Exchange is to be of like-kind. That is, new property must be of the same nature as the property being “exchanged” or replaced. Quality and size are secondary factors in the 1031 Exchange; rather, emphasis is placed on value.
This means an investor can exchange a 10-unit apartment building for a 20-unit apartment building, an office building, or even a plot of land – as long as the two properties share the same purpose of business or investment.
Personal and intangible property, such as machinery and equipment, belongings, or patents and intellectual property, are not included in the exchange – so know that only the property itself is eligible for tax deferral.
There are incentives available for certain Opportunity Zones carved out by the Cuts and Jobs Act of 2017 that encourage long-term investments in low-income areas. Eligibility is determined by zone, so check your state and local guidelines for opportunity zones within your area that may be eligible for additional tax-deferral and incentives.
Mortgages on rental property can also qualify for a 1031 Exchange, as long as the replacement mortgage is of equal or greater value than the current mortgage. The same timeline and like-kind property rules apply when qualifying mortgages for a 1031 Exchange.
Common Types of Exchange
There are five common types of the 1031 Exchange.
A delayed exchange involves selling one property and purchasing the replacement property within a set window of time. A delayed/simultaneous exchange involves purchasing a replacement property at the same time of selling the first.
A delayed reverse exchange involves purchasing a replacement property before selling the initial, and then following with the sale of the initial property in a set amount of time.
A delayed built-to-suit exchange involves replacing a current property with a new property that is built-to-suit the needs of the investor, such as office space.
Lastly, a delayed/simultaneous build-to-suit exchange involves purchasing the replacement built-to-suit property before selling the current property.
Note that before or while a replacement property is purchased, investors cannot receive proceeds from the sale of the current property. Instead, the proceeds are held in escrow by an accommodator, or a 1031 Exchange intermediary, until the replacement is officially purchased. Intermediaries can be found by contacting a professional close to you, such as your lawyer or accountant, for a referral.
Rules to the 1031 Exchange
As mentioned earlier, it’s important to follow the rules of the 1031 Exchange exactly in order to avoid paying taxes on capital gains. Remember, this exchange requires a fair amount of planning ahead. Be sure to read up on the rules before finding a replacement property so you know what to expect.
When it comes to finding replacement property, the new purchase must be of equal or greater value than the one being sold. With that said, you’ll need to have property value in mind when identifying the replacement to be sure the value adequately meets the exchange requirement.
Replacement property must be identified within 45 days of sale and purchased within 180 days. Once you sell the current property, the IRS will only allow 45 days to identify a replacement to qualify for a 1031 Exchange. A savvy investor will jump-start the replacement process by identifying potential properties before the current one is sold. This will help you get a fair price on a quality property that will strengthen your portfolio.
Once you’ve identified the replacement property, the purchase must be finalized and closed by 180 days from the sale of the initial property. Remember, the IRS counts each individual day (including weekends and holidays!), so stay on top of your timeline.
The Magic of the 1031 Exchange
Remember, 1031 Exchanges won’t allow you to avoid taxes completely, but they can be a helpful tool to defer paying capital gains taxes, and thus open the door to grow your investment portfolio. The 1031 Exchange is like taking an interest-free loan from the IRS, where you can reinvest the money into a property of higher value that may even produce a higher income.
The 1031 Exchange offers a great opportunity for investors to grow their portfolios, and the IRS benefits by encouraging business and reinvestments. By learning the rules and regulations, savvy property owners can save time and money in the present, all while growing their portfolio.
