1031 Exchanges: How This Rule Could Save You Thousands of Dollars Investing in Real Estate
What is a 1031 Exchange?
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. A 1031 exchange is a swap of one investment property for another that allows capital gains taxes to be deferred. Gain deferred in a 1031 exchange is tax-deferred, but it is not tax-free.
If you own investment property, a 1031 exchange allows you to avoid paying taxes on the sale of your property if you reinvest in another investment property of equal or greater value. By not paying taxes on the first sale, you will have more money to put towards a greater replacement investment property, saving you thousands of dollars in the short term and earning you even more down the road. The term “1031 exchange,” sometimes just “1031” gets its name from IRS code Section 1031.
How does a 1031 exchange work?
Typically, whenever you sell your investment property, the proceeds of that sale are significantly taxed as “capital gains.” However, if you do a 1031 exchange, you can avoid those taxes altogether. The reason is that Section 1031 of the Internal Revenue Code (26 U.S.C. 1031) allows you to “exchange” similar properties (called “like kind”) and defer the taxes (called “non-recognition”) until the second property is later sold, thus freeing more capital for investment in the second property.
“Like-kind” is probably not what you think. The rules are surprisingly liberal. You could exchange an apartment building for a plot of land or a ranch for a brownstone. There is no limit on how many times or how frequently you can do a 1031 like kind exchange. Additionally, any investments can continue to grow tax deferred as you roll over the gain from one piece of real estate investment to another.
Who qualifies for a 1031 Exchange?
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
What types of properties qualify for a 1031 Exchange?
The type of property that qualifies for a 1031 exchange is limited to real property (i.e., tangible, not like stocks) held for productive use in a trade or business, or for investment. In other words, it must be land or a commercial building that you use for trade, business, or investment. Hence, many properties in the real estate investment world do not qualify, such as real property held primarily for sale (e.g., flipping properties), personal residence, or personal property. For example, vacant land can be exchanged for a commercial building. However, real estate cannot be exchanged for artwork or stocks. Furthermore, to enjoy the tax deferral benefits of 1031, the property must be similar and of same or greater value.
How do I exchange property under Section 1031?
To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of 1031 exchange is a simultaneous swap of one property for another.
Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
To qualify as a 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposal of the relinquished property and acquisition of the replacement property must be mutually dependent parts of one transaction comprising an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations.
A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred. If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet 2 time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name.
The second limit is that the replacement property must be received, and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
Are there restrictions for deferred and reverse exchanges?
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make all gain immediately taxable. If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete. You cannot act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) cannot act as your facilitator.
Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
What if I want to move into my investment property that I recently swapped?
If you want to use the property you swapped for as your new second or even primary home, you won’t be able to right away. During the first year after the exchange, you must rent to another person for a fair rental for 14 days or more. In addition, your own personal use of the dwelling unit cannot exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
To be sure, Section 1031, like any other tax code, is a complex, rule-oriented provision that must be strictly complied with to reap its benefits. But done correctly, the return for complying with the provision is worth the thousands of dollars you can save and the potential thousands you may earn in the future. Accordingly, you should consult with an experienced real estate attorney to ensure you comply with 1031’s strict guidelines.
GLO has specialized in helping real estate investors in the Denver/Boulder area and along the Front Range avoid legal pitfalls in purchasing Colorado real estate. If you have any questions about like kind exchanges or investing in Colorado real estate, fill out an interest form today to see if GLO can help you.
GLO has prepared this blog to provide general information on legal issues that may be of interest. This blog does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and GLO or its attorneys. GLO engages clients only through specific fee arrangements and signed engagement letters. GLO does not guarantee any results.