Clients often ask us about 1031 Exchanges. In the simplest of terms, 1031 Exchanges allow real estate investors to defer their capital gains liability and build wealth by exchanging one property for another of similar kind. If you own a rental property that is worth significantly more today than what you purchased it for, you can increase your investment using this powerful strategy. But like so many tax-efficient planning strategies, there are many rules and guidelines to navigate.
What Is a 1031 Exchange?
A 1031 Exchange allows real estate investors and businesses to swap one investment property for another with the main benefit of a deferred tax status. Normally sellers pay capital gains taxes on their profits after closing the sale of an investment property. However, if done as a 1031 exchange, the profits can be reinvested, tax-free, in the purchase of another investment property.
There is no limit to the number (or frequency!) of 1031 Exchanges an investor or business can do. This means profits from the sales of each investment property can be continuously reinvested in new properties. Once this cycle ends, the profits from the final sale are taxed at a single long-term capital gains rate. (As of 2020, this is 15% or 20% — depending on your income — or 0% if your taxable income is less than $78,750.) But in practice, you can use a 1031 Exchange to swap nearly any two investment properties within the United States, regardless of property type.
Types of Exchanges
Simultaneous Exchange – A simultaneous exchange occurs when the replacement property and the current property close on the same day.
Delayed Exchange – The delayed exchange, which is the most common, occurs when the current property is sold before the replacement property is acquired. In this case, a third-party Exchange Intermediary would be hired to “hold” the funds until a replacement property is purchased. Using this strategy, an investor has a maximum of 45 days to identify the replacement property and 180 days to complete the sale of their property. In addition to the numerous tax benefits, this extended timeframe is one of the reasons that the delayed exchange is so popular.
Reverse Exchange – Also known as a forward exchange, a reverse exchange occurs in theory, when you buy first and you exchange later. What makes reverse exchanges tricky is that they require all cash and many banks won’t offer loans for reverse exchanges. The reverse exchange follows many of the same rules as the delayed exchange. However, there are a few key differences to note:
- Taxpayers have 45 days to identify what property is going to be sold as “the relinquished property.”
- After the initial 45 days, taxpayers have 135 days to complete the sale of the identified property and close out the reverse 1031 exchange with the purchase of the replacement property
Construction Exchange – The construction exchange allows the taxpayer to use their tax-deferred dollars to make improvements to the replacement property while it is placed in the hands of a qualified intermediary for the remainder of the 180 day period. The entire exchange equity must be spent on completed improvements or provided as a down payment by the 180th day. The taxpayer must receive “substantially the same property” that they identified by the 45th day. In addition, the replacement property must be equal or greater in value when it is deeded back to the taxpayer. The improvements must be in place before the taxpayer can take the title back from the qualified intermediary.
Rules & Guidelines
Here are the rules and guidelines governing 1031 Exchanges at the time of writing:
“Like Kind” – As defined by the IRS: “Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.
Same Tax Payer – The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and titleholder that buys the new property. However, an exception to this rule occurs in the case of a single-member limited liability company (such as “Lisa Smith LLC”), which is considered a pass-through to the member. Therefore, the “Lisa Smith LLC” may sell the original property, and “Lisa Smith” may purchase the new property in her individual name.
45 Day Identification Window – The property owner has 45 calendar days, from the closing of the first property, to identify up to three potential properties of like-kind. An exception to this is known as the 200% rule which allows you to identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
180 Day Purchase Window – It’s necessary that the replacement property is received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
Holding Period – When can you sell your investment property? Many advisors believe two years is a conservative holding period, provided no other significant factors contradict the investment intent. Other advisors recommend a minimum of at least twelve months as this means the investor will usually reflect it as an investment property in two tax filing years. Regardless of the length of holding, it is necessary to be able to provide proof that the property has been in fact used as an investment.
Avoiding Depreciable Properties – If you exchange your property for another property that is underdeveloped or otherwise seen as a “depreciable asset”, this will trigger an event called a “Depreciation Recapture”. In this scenario, your profit would be taxed as normal income.
Becoming a Primary Residence – If you wish to establish a property from a 1031 Exchange as your primary residence, you must be patient. Within the first 24 months following the exchange you must rent the property to another person at a fair rental value for at least 14 days. Your own personal use of the dwelling unit cannot exceed either 14 days or 10% of the number of days during the 12-month period that the property is rented (whichever is larger). Using a property from a 1031 Exchange as a primary residence could also complicate your tax situation down the road. The IRS makes clear that living in the property means you will be delayed in receiving up to a $500,000 exclusion of your exchange profits subject to capital gains tax.
Converting Vacation Properties – Converting a vacation property into a 1031 Exchange-eligible investment property requires planning. Let’s say you wanted to swap your mountain cabin for another property. You would need make it available to rent, and have tenants occupy the property for at least six months or (preferably) a full year. While there is no absolute standard about the duration of the rental, the longer you rent it out, the more likely the IRS will allow you to move forward with the exchange.
While 1031 Exchanges may limit your liability to a long-term capital gains payment, there are other tax implications to consider.
For example, it is common for these swaps to leave investors with cash left over. This is the case when the property you purchase is of lower market value than the like-kind property you sold. In this case, the intermediary will pay you the difference at the end of the 180-day exchange period. That difference, or “boot”, will be taxed as partial sales proceeds from the sale of your property, usually as a capital gain.
In addition, any reduced mortgage liability as a result of a 1031 Exchange will also be treated as taxable income. Suppose the mortgage on your old property was $500,000, but the mortgage on the new property is $400,000. That $100,000 difference is also considered “boot”, and will be subject to capital gains tax.
1031 Exchanges are indeed a great way for savvy real estate investors to limit their tax liability. However, there are many rules and qualification requirements that you must comply with in order to perform a successful exchange. It’s important that you choose your replacement property (or properties) wisely and invest in a market that has good potential for growth in the future. For anyone interested in doing a 1031 Exchange, Arrive Real Estate Group would be happy to lend our expertise to make this as smooth a process as possible.