1031 Exchanges Explained

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In simplest terms, a 1031 exchange is a tax strategy that allows you to defer capital gains taxes when you sell a real estate property, by reinvesting the profits into another “like-kind” asset.

Capital gains tax is a levy assessed on the positive difference between the sale price of an asset and its original purchase price. The rates are 0-20% depending on your tax bracket.

For example, if you paid $100,000 for a property and you’re allowed to claim $5,000 in depreciation, you’ll be treated subsequently as if you’d paid $95,000 for the property. The $5,000 is then treated in a sale of the real estate as recapturing those depreciation deductions. The tax rate that applies to the recaptured amount is 25%. So if the person then sold the building for $110,000, there would be total capital gains of $15,000. Then, $5,000 of the sale figure would be treated as a recapture of the deduction from income. That recaptured amount is taxed at 25%. The remaining $10,000 of capital gain would be taxed at one of the 0%, 15%, or 20% rates.

The brilliance of the 1031 exchange is that you can avoid being taxed on your capital gains by reinvesting them into a new “like-kind” property. So this method not only provides amazing tax benefits, but also motivates investors to think long term about their investments. One of the most crucial components of your real estate investing plan is your “exit strategy,” or your plan to eventually remove yourself from a deal at its most cost-effective juncture. A 1031 exchange forces you as an investor to understand and carry out your exit strategy.

Before pursuing a 1031 exchange, it is important to understand some of the relevant rules and regulations:

  1. Properties must be “like-kind”

    • You can essentially exchange almost any type of investment real estate for another type of investment real estate, including raw land, residential, and commercial properties. Generally, the replacement property should be of equal or greater value than the relinquished property. And both properties must reside within the U.S. to qualify.

  2. Timeframe regulations:

    • The first relates to the designation of a replacement property. Once the sale of your property occurs, the intermediary will receive the cash. You can't receive the cash, or it will spoil the 1031 treatment. Within 45 days of the sale of your property, you must designate replacement property in writing to the intermediary, specifying the property you want to acquire. The IRS says you can designate three properties so long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.

    • The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old. Note that the two time periods run concurrently. That means you start counting when the sale of your property closes. If you designate a replacement property exactly 45 days later, you'll have just 135 days left to close on the replacement property.

  3. Tax implication and mortgages:

    • One of the main ways people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property you relinquish, and any debt on the replacement property. If you don't receive cash back, but your liability goes down—that, too, will be treated as income to you, just like cash.

    • Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. You have $100,000 of gain that is also classified as "boot," and it will be taxed.

Now, with a basic understanding of some of the important rules and regulations, we can look at an actionable plan of implementation.

A step-by-step guide to do a 1031 Exchange

  1. List your property and stipulate your desire to do a 1031 exchange. Weigh the benefits of a 1031 exchange against the requirements of pulling it off correctly. And always consult with your accountant on the legal and financial ramifications of such a decision.

  2. Immediately begin looking for a replacement property. Remember, you have 45 days to purchase this property from the day you relinquish your property. This is not a lot of time, and as such it’s crucial to have a pipeline of readily available properties, or to work with an agency that can supply you with great replacement properties.

  3. Find a qualified intermediary (QI) whom you can trust to stand-in for you (during the purchase and the sale) and transfer the deed of the acquired property to your name. In a general sense, your QI is responsible for holding the proceeds and preparing legal documents in an effort to perform the transaction according to IRS guidelines

  4. Negotiate and accept your offer. Ensure that your buyer understands the 1031 exchange procedure, and have them sign any pertinent disclosures

  5. Close on the sale of your relinquished property. Your attorney and QI will oversee this process, and the funds will transfer to your QI, not you.

  6. Identify up to three properties within the 45 day window.

  7. Sign the contract on your first choice replacement property. If you are unable to choose one property at this point, you can get multiple properties under contract and include contingency clauses to forgo whatever properties you don’t ultimately pursue

  8. Have your qualified intermediary close the deal. Your QI will wire you your money, and the property will close as normal, deferring your requirement to pay capital gains taxes until some future point in time.

You can repeat this process of deferring taxes indefinitely, thereby evolving your investment portfolio and growing wealth long term.

Eventually, most investors will sell off their real estate investment portfolio as they approach retirement. Should you choose to cash out, it will be time to pay the piper, aka the IRS. At this point you are paying the taxes on all the properties for which you have ever utilized the 1031 exchange. If, however, you’d still like to avoid this hefty taxation after selling off your portfolio, you do have some options, including passing your properties onto your heirs. Additionally, by trading up into more easily manageable properties, you can limit the number of your investment properties to just a few large scale deals. You might exchange a number of residential properties for equity in a commercial syndication, or a triple net (NNN) lease investment in which the tenant pays for everything while you collect. Ultimately, it is worth exploring the 1031 exchange as a viable wealth building - and protecting -tool in your investment career.

1)  https://www.irs.gov/pub/irs-pdf/p550.pdf

2)  https://www.livefreeinvestments.com/blog/2019/8/29/1031-exchanges-10-things-to-know