The 1031 Exchange takes its name from Section 1031 of the Internal Revenue Service code. Section 1031 allows for a taxpayer to suspend the recognition of capital gains and/or related federal income tax liability onto the exchange of property. When done successfully, a 1031 Exchange can allow investors to defer taxes on capital gains almost indefinitely.
There is no limit to how many exchanges you can make under a 1031 Exchange. Since you can make as many as you want, 1031 Exchanges can help you save money and built significant wealth quickly.
A successful exchange requires that an investor follows certain rules and processes. So, in today’s blog, we’ll provide you with answers to commonly-asked questions pertaining to 1031 Exchanges!
What Kinds of Properties Qualify?
Not all kinds of properties can be used within a 1031 Exchange. Only real property that you’ve held as an investment or for business use are qualified to be used in this exchange. Your primary residence, for example, is a property that wouldn’t qualify under the program.
Other properties that may not qualify include:
- Fix-and-flip properties
- Second homes or vacation properties that are not held for investment purposes
- Land that is solely under development for resale
- Notes, bonds, stocks, and beneficial interests
For a property to qualify under the code, it must take the form of an exchange rather than a sale of one property for another. They must also be “like-kind,” that is, those that share the same nature or character. The following are examples of exchanges that may be viable:
- Improved real estate for raw land
- A ranch for oil and gas royalties
- Industrial, commercial, or residential rental properties for a real property
What Rules Must an Investor Follow for a Successful 1031 Exchange?
Being “like-kind” isn’t the only requirement that properties must meet when being considered for an exchange. Other rules required under Section 1031 of the IRS code include:
1. The Exchange Must Be Set Up by a Qualified Intermediary
Before the exchange commences, the services of a Qualified Intermediary must be engaged. A Qualified Intermediary is an unrelated party that facilitates the exchange of a relinquished property for the replacement property as per the exchange agreement. Basically, their role is to ensure that the process goes as it's supposed to.
By having a qualified third-party facilitate the exchange, it prevents the investor doing the exchange from having a “constructive receipt.”
2. The Replacement Property Must Have a Similar or Greater Value
The property you’re exchanging your current property with must have equal or greater value, minus the sale costs. Examples of costs associated with selling a property include brokerage fees and attorney fees.
For example, suppose you’re selling a property for half a million dollars and the sale costs are $25,000. This means that the replacement property must have a value of at least $475,000.
3. You’ll Have 45 days to Identify the Replacement Property
The 45-day window is known as the identification period. You’ll have 45 days from the date of the sale of the relinquished property to identify the potential replacement property. There are options for an investor when it comes to replacement property identification.
One option is the 95% Rule. According to this rule, you must acquire 95% of the total aggregate fair market value of all the properties identified.
The second option is the 200% Rule. Under this rule, you can identify an unlimited number of replacement properties so long as their combined value doesn’t exceed 200% of the property being relinquished.
Lastly, there's the 3 Property Rule. This rule will allow you to identify up to three properties as potential purchases, regardless of their market value.
The 45 days are measured from the date the first relinquished property closes. Once this period is over, you cannot include or acquire new replacements.
4. You’ll Have 180 Days to Complete the Exchange
You must adhere to the 180-Day rule in a 1031 Exchange. This rule states that the total transaction must be completed within 6 months (180 days). This rule applies to all property types involved in an exchange.
5. The Taxpayer Selling or Acquiring an Exchange Property Must Be the Same
The person who the title names at the time of closing must be the same person performing the exchange.
If anyone else is mentioned in their place, it will not qualify.
6. Capital Gains Must Be Paid on “Boot”
In 1031 exchanges, “boot” is referred to as a property that isn’t like-kind. Boot can take different forms, including cash, an installment note, or debt relief. It’s appraised at the fair market value of the non like-kind property received.
The Internal Revenue Service (IRS) considers boot as taxable income since it’s an economic benefit. The purpose of 1031 Exchanges, according to the IRS, is to incentivize taxpayers to grow their investments.
What Are the Different Types of 1031 Exchanges?
There are three ways in which a 1031 exchange can be conducted:
Delayed 1031 Exchange
This is the most common type of 1031 exchange. It allows investors the flexibility of up to 180 days to purchase a replacement property. A qualified Intermediary is necessary to oversee the exchange.
Reverse 1031 Exchange
This is the opposite of a delayed exchange. Real estate investors use a Reverse 1031 Exchange when looking to buy a new property before selling the one they currently have.
So, unlike in a delayed exchange, a reverse exchange allows you to obtain a replacement property first and then sell your current one.
Build-to-Suit 1031 Exchange
This kind of exchange allows an owner to use the proceeds from the sale of relinquished property not only to get a replacement property, but to improve it as well. This is ideal for growing businesses that needs more space for expansion. This type of exchange is still subject to the time frames and requirements of a 1031 Exchange.
Basically, a 1031 Exchange is like having an interest-free loan from the IRS. Rather than pay capital gains tax, you can put that extra money to grow your portfolio and enjoy a better Return on Investment (ROI).
1031 exchanges are highly beneficial to property owners. By understanding the details involved in this, you can be sure to provide a major boost your real estate investments.
If you have further questions on 1031 exchanges or on any aspect of property management, contact Gifford Properties & Management! Whatever your property needs may be, we have you covered. We'd be happy to speak to you about our services!