What Is a 1031 Exchange and How Does It Work?
The 1031 exchanges are swaps of real estate investment properties that allow capital gains taxes to be deferred. Real estate agents, title companies, investors, and others use this term, derived from Section 1031 of the Internal Revenue Code (IRC). Some individuals even insist on using it as a verb like, “Let’s 1031 the building for another.”
Real estate investors need to understand what Section 1031 involves before attempting to use it. It is possible to exchange only like-kind properties, and the Internal Revenue Service (IRS) limits its application to vacation properties. Additionally, tax implications and timeframes may be problematic.
Here are the basics about 1031 exchanges if you're considering one or just curious about it.
What Is A 1031 Exchange?
A 1031 exchange (also called a like-kind exchange or a Starker exchange) involves swapping one investment property for another. In most cases, swaps are taxable, but if the swap meets 1031 requirements, you may not owe any or only limited taxes after the exchange.
Essentially, you can change the form of your investment without recognizing capital gains or cashing out. Tax-deferred growth allows your investment to continue growing. The number of times you can do a 1031 exchange isn't limited. It is possible to roll over gains from one investment property to another and another and another.
Even though you may make money on each swap, you avoid paying taxes until you sell for cash many years later. In this scenario, you'll pay only one long-term capital gains tax (currently 15% or 20%, depending on income, and 0% for some low-income taxpayers as of 2022).
For exchanges to qualify, they must be of like kind-an enigmatic phrase that can be misunderstood. A ranch can be exchanged for a strip mall, or an apartment building can be swapped for raw land. It is surprising how liberal the rules are. There are even traps for the unwary when it comes to exchanging one business for another.
Although the 1031 provision applies mostly to investment and business property, the rules can be applied to a former principal residence if certain conditions are met. It is also possible to use 1031 for swapping vacation homes, but this loophole is much narrower than it used to be.
Special Rules for Depreciable Property
When a depreciable property is exchanged, special rules apply. Depreciation recapture can lead to ordinary income being taxed as a profit. It is generally possible to avoid the recapture of a building when you swap one for another. However, the depreciation you've already claimed on the building will be recaptured as ordinary income if you exchange improved land with a building for unimproved land without a building.
A 1031 exchange can be complicated, which is why you need professional assistance.
Changes to 1031 Rules
Personal property exchanges, such as franchise licenses, aircraft, and equipment, were eligible for 1031 exchanges before the passage of the Tax Cuts and Jobs Act (TCJA) in December 2017. Currently, only real property (or real estate) qualifies as defined in Section 1031. In any case, TCJA's full expensing allowance for tangible personal property may make up for this tax law change.
Under the TCJA, qualified personal property can be exchanged in 2018 if sold or acquired by December 31, 2017. Specifically, the transition rule does not permit a reverse 1031 exchange where the new property is purchased before the old property is sold.
How Does A 1031 Exchange Work?
By selling a property and putting the proceeds toward a like-kind property, a seller can postpone capital gains taxes.
In the absence of any proceeds, there is no income to be taxed. It means you don't make any money from the sale. This is the idea behind a 1031 exchange, and here's how it works.
Step 1: Decide which property you are interested in buying and selling
Identifying which property to exchange and which property to sell is the first step. The property you sell and the property you buy must be similar, but not necessarily the same grade or quality.
Step 2: Select a qualified intermediary
To complete a 1031 exchange transaction, you need to work with a qualified intermediary, also called an exchange facilitator. Qualified intermediaries hold your funds in escrow until the exchange is completed. To avoid losing money, missing deadlines, or paying taxes later, you need to carefully choose the right qualified intermediary.
Step 3: Inform the IRS of your transaction
Lastly, you'll need to file IRS Form 8824 with your tax return so the IRS knows about your transaction. A property description, a timeline, an explanation of who was involved in the process, and an estimate of the cost will all appear on that form.
To sell or buy the replacement property, both the relinquished property and the replacement property must meet certain requirements.
In a 1031 exchange, the relinquished property is exchanged for another. This is known as Phase 1 or Downleg.
Replacing a property means buying a like-kind parcel with the proceeds of the relinquished property.
What Is A Qualified Intermediary?
Qualified intermediaries sell your property on your behalf, buy the replacement asset, and then transfer the deed to you.
A qualified intermediary has a wide range of responsibilities, including:
- Coordinate the 1031 exchange structure with you, the seller.
- Prepare the documentation for relinquished assets and replacement properties.
- Instruct the escrow or title company about the exchange and provide the appropriate documents.
- Establish an arm's length transaction between the seller or exchanger and the qualified intermediary.
- Ensure the asset is conveyed to the buyer through a qualified intermediary.
- Deposit funds received from the sale of the relinquished property in a separate, insured account.
- Hold onto the sale proceeds of the relinquished property for 45 days to identify the funds.
- Keep written information about potential replacement properties.
- Disburse funds to the title or escrow company for the purchase of the replacement property once the replacement property has been selected.
- Provide the seller or exchanger with a deed conveying the title.
- Maintain complete records for the seller.
- For interest, give a 1099 form to the seller or exchanger and the IRS if necessary.
Choosing The Right Qualified Intermediary
Choosing the right qualified intermediary is crucial. You should confirm that the qualified intermediary you are considering offers the following services:
- Real estate experience: What is the experience level of the qualified intermediary in real estate?
- Completion of compliance examinations: Processors should undergo annual compliance examinations, such as SSAE 16.
- Transparency in transactions: Do you have access to your exchange money at all times? You need to know what's happening with your money.
- Fund security: Hold your funds in an FDIC-insured account to ensure their safety.
When To Use A 1031 Exchange
You might want to use a 1031 exchange for several reasons. You may want to:
- Choose a property with better return prospects than your current investment.
- Combine several properties into one, perhaps as part of an estate planning process.
- Reset the property’s depreciation.
- Make your vacation home a rental property and do a 1031 exchange. For example, you would stop using your beach house, rent it out for a few months, and then exchange it for another property.)
- Invest in more than one property after selling your investment property. If you want, you can buy three investing properties - there is no limit. The qualified intermediary will have to discuss extra rules for financing multiple rental properties with you if you purchase more than three.
1031 Exchange Rules And Requirements
Here are the rules and regulations about the 1031 exchange, including property and time requirements.
You must comply with certain requirements when exchanging property:
Replaced property must be like-kind or of equal or greater value than the relinquished property. For two properties to qualify as like-kind, they must be similar enough. There are a lot of real estate properties that are like-kind to each other. The improvement of real property with a residential rental house is like-kind to an empty land, for instance. Note that property within the United States differs from property outside the country.
There must be a similarity in nature and function between the exchanged properties. An exchange of a rental or multifamily property cannot be used to acquire a vacation home, for example. Residences used exclusively for personal purposes, such as a primary residence, second residence, or vacation home, do not qualify as like-kind exchanges. Under Section 1031, both actual and personal property (including machinery, equipment, collectibles, vehicles, boats, airplanes, artwork, patents, and other intellectual property) can qualify as exchange properties, but actual property is never like-kind to personal property. Personal property is also subject to more restrictive rules. Cars, for instance, are not like-kind to trucks.
Any money made from a sale during the exchange cannot be held. For proceeds to be tax-free, funds must be held in escrow by a qualified intermediary.
In addition, Section 1031 does not apply to these types of exchanges:
- Stocks, bonds, or notes
- Other securities or debt
- Partnership interests
- Trust certificates
As part of a 1031 tax exchange, you also must adhere to certain timelines or your gain may be taxed:
After the sale of your relinquished property, you have 45 days to find a replacement property. In this case, you must provide the seller with a written statement and share it with your qualified intermediary.
Replace the relinquished property within 180 days of completing the tax return or closing on the replacement property.
Types of 1031 Exchanges
Three types of tax-deferred exchanges may be of interest to you: delayed exchanges, reverse exchanges, and build-to-suit exchanges.
The most common exchange format is a delayed exchange, which gives you up to 180 days to find a replacement property. A qualified intermediary receives the sale proceeds if you sell your relinquished property before acquiring your replacement property. Until you acquire the replacement property, your qualified intermediary holds the funds and delivers them to the closing agent.
In a reverse exchange or forward exchange, the replacement property is purchased before the relinquished property is sold. If you are facing competing offers or pressing closing dates, you could use this option to find a replacement property when it is a seller's market.
If a replacement property is purchased before the sale of the relinquished property, the property must be transferred through an exchange accommodation titleholder - a qualified intermediary.
Built-to-suit exchanges, also known as improvement exchanges and construction exchanges, are exchanges in which deferred tax dollars are used to renovate the replacement property. It is necessary to complete the improvements within 180 days.
Tax Implications of a 1031 Exchange
There may be some tax implications associated with a 1031 exchange, including:
- It is possible to make capital gains on leftover cash, known as the "boot," after an exchange.
- In the case of a replacement property with a lower mortgage than the relinquished property, the difference may be taxed.
- Should the sale fail, you will be taxed for the relinquished property.
- Performing many 1031 exchanges over the years can result in deferred gains numbering in the hundreds or thousands, increasing your tax liability.
Real estate investors can benefit from 1031 exchanges by purchasing more profitable properties, growing their portfolio, postponing capital gains tax, and reinvesting earnings. The IRS has strict requirements and timelines for 1031 exchanges, so it is important to have a qualified intermediary assist you and ensure that the transaction is completed properly. Successful investment in real estate successfully takes time and thorough research.
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