Squeezing Uncle Sam With The 1031 Exchange
By Jaye Abbate
Despite rising real estate values across the country, property investors continue finding creative ways to make their investment dollars work for them. One of the most powerful methods for building real estate holdings includes the use of 1031 Exchanges, which allow investors to defer capital-gains taxes on investment property by reinvesting sale proceeds into the purchase of new property within a set timeframe. Though 1031 Exchanges have grown in popularity, as the sheer number of active real estate investors has multiplied, 1031 misperceptions and misapplications continue. What follows are answers to seven basic, but frequently asked, 1031 Exchange questions.
- What is a 1031 Exchange?
- Why do a 1031 Exchange?
- How do I start and what are the basic ground rules?
- What if you can’t locate a property within 45 days?
- Is there a limit to the number of properties that are identified in the 45-day period?
- Is there a limit to the number of properties I can “exchange?”
- What are “qualifying properties?”
- Trading Up With A 1031 Exchange
What is a 1031 Exchange?
Simply put, Section 1031 of the Internal Revenue Tax Code is a tax-avoidance tool that allows you to defer capital gains tax to a later date when selling a piece of investment property, thereby allowing you to reinvest money received from the sale into another property. You are, in essence, “exchanging” one property for another investment property (or properties) of equal or greater value. When the “replacement” property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
Why do a 1031 Exchange?
For investors, there are three primary advantages to doing an exchange:
To grow your real estate portfolio: Deferring your tax burden is like getting an interest-free loan on the tax dollars you would have owed on your property sale. Your immediate tax savings is, thereby, used as investment capital in a replacement property. This is of particular interest to those wishing to increase their portfolio. If the original property has had significant appreciation, the equity extracted from the exchange might be enough to afford multiple properties or a decent sized multiplex.
To turn your “gain” into immediate equity and tax-free cash:
Once your existing property is sold and the replacement property is purchased, you can subsequently refinance the new property, and take cash out without having to pay income or capital gains tax. (Keep in mind your proceeds will be subject to taxation later -if and when you were to sell a replacement property without performing another 1031 Exchange.)
To use as an estate planning tool: Families that intend to pass along real estate holdings typically deed them into a family partnership or LLC (limited liability company). Heirs will inherit the property without taxation and can continue the 1031 Exchange process without interruption.
How do I start and what are the basic ground rules?
The first step is to enter into a contract to sell your property and then identify a property for purchase. While the buyer can be “anyone,” the prospective replacement property must be specifically identified in a written document signed by you and executed with a qualified 1031 intermediary. This must be done within 45 days of relinquishing your original property and the exchange, or purchase of the new property must be “closed” within 180 days after the transfer of your original property. Sale proceeds must be held in an escrow account with an exchange agent, or qualified intermediary, until your “exchange” is complete. Also, all equity proceeds from the sale must be reinvested in the replacement property.
There are no extensions available. Therefore, it is critical that you start searching for property as soon as you feel your sale is imminent, and try to time the closings accordingly. It might even behoove you to select more than one property (see restrictions in the next section) in case your first selection runs into problems.
Is there a limit to the number of properties that are identified in the 45-day period?
The 1031 requirements allow you to identify more than one property as a potential replacement. You can select up to three properties without regard to fair market value. Or, you may identify any number of properties provided that the total value does not exceed 200 percent of the value of the original property you are selling. You don’t have to close on all properties. Remember that you must be in compliance with these requirements, or you may find yourself subject to a hefty capital gains tax!
Is there a limit to the number of properties I can “exchange?”
You can “exchange” a single property for multiple properties. Likewise, you can purchase just one property from the proceeds of several, as long as all the related timeline, identification and value requirements are met.
What are “qualifying properties?”
Properties exchanged must be of “like-kind,” which generally means property of greater or equal value. You may exchange a duplex for a five-story building, or even a vacant lot, as long as you meet all other 1031 requirements, including the holding time required before reselling real estate. Property exchanged must be held for productive use in trade, business or investing, which can include a residential rental property, strip mall, warehouse or land held for speculative investment. Personal residences or land a developer holds in inventory to sell later are not allowed. While it is possible for property purchased in an exchange to be converted at a later date to a primary residence, or for a vacant lot to ultimately be sold to a developer, it is tricky. So, it’s advisable for you to consult with a 1031 expert and wait at least two full tax years before doing so.
Trading Up With A 1031 Exchange
As you can see, the tax-deferred exchange is a great way to build up your net-worth and maximize your investment dollars. And there are many more nuances to the 1031 tool not covered in this article, which sophisticated property investors regularly employ, such as using them in conjunction with “triple net leases.” The regulations regarding 1031 Exchanges are complex, can vary from state to state and are subject to change by the IRS. Therefore, it’s best for you to speak on a regular basis with a professional trained in these transactions, as well as with an accountant, prior to engaging in a 1031 Exchange. Once done, you will be able to trade-up on a tax-free basis and amass a substantial real estate portfolio using the tax code to your advantage.
The Four Steps In A 1031 Exchange
Enter into a contract to sell your property and identify a property (or properties) of equal or greater value for purchase.
Retain a qualifies 1031 intermediary firm to assist you with the process and handle the formalities of the escrow account.
Designate the replacement property you wish to purchase within 45 days of relinquishing the original property – and do so in writing with the 1031 intermediary.
Close on a replacement property within 180 days of the sale of the original property. All equity proceeds must be reinvested in the replacement property.
Information taken from Property Investor Magazine