A 1031 exchange can be described as a tool for real estate investors to swap one investment property for another. In doing so, investors are able to defer capital gains tax, which is levied on the sale of a property. This effectively reduces the overall cost of the transaction.
The process gets its name from Section 1031 of the Internal Revenue Code which permits the exchange of two investment properties of a similar kind. Such an exchange is allowed on the condition that the rules of the Internal Revenue Service are followed. Real estate investors are thus able to defer these tax obligations until they decide to sell the property.
The 1031 exchange is a very useful tool for real estate investors as they seek to grow their wealth. In this guide, we will discuss some of the elements of a 1031 exchange and how you can apply them to expand your real estate business.
How the IRS Defines 1031 Exchanges
According to Section 1031 of the Internal Revenue Code, an investor can defer taxes with the exchange of a “like-kind” property. In this context, like-kind properties are viewed as real properties that are held for business or investment purposes that are similar in nature.
This statute was passed by Congress in 1921 to encourage reinvestment and to avoid taxation of ongoing investments.
In 1984, changes to Section 1031 were passed in Congress under the Tax Reform Act. These changes further defined the meaning of a “like-kind” property and the time frame for completing such an exchange. Let’s take a look at this in greater detail.
What Properties Qualify for a 1031 Exchange?
As previously mentioned, 1031 exchanges are only permitted for real properties that are held for the purpose of business or as an investment. Therefore, personal residences and properties that are bought solely for resale do not qualify for this exchange. Second homes or vacation residences that are not held for rent also fail to qualify for a 1031 exchange.
Other properties that don’t meet the criteria include land that is under development as well as interests such as stocks, bonds, and partnership interests in property.
For a transfer to qualify for a 1031 exchange, it needs to take the form of a swap, not a mere sale followed by the purchase of another property. Here are some examples of real properties that are considered “like-kind”.
- An apartment building that is exchanged for an industrial property
- A farm in exchange for an office building
- A shopping center that is exchanged for bare land
- Bare land in exchange for industrial property
The IRS does not necessarily consider the level of development for a property to meet the “like-kind” criteria. This means that an investor can exchange an apartment building for a larger one, or an office building for a shopping center. However, the rules for a 1031 exchange need to be followed word for word.
Time Frames for 1031 Exchanges
Before the Tax Reform Act of 1984 was passed, 1031 exchanges were meant to take place simultaneously. However, the exchanges faced a number of challenges such as finding a suitable property and the difficulty in making simultaneous transfers for property titles and funds. This led to the introduction of delayed 1031 exchanges in the 1984 reforms.
However, with the introduction of delayed 1031 exchanges, also came strict timelines for the transactions. The exchange also needs to be done through a qualified intermediary, who holds the funds after you sell your property and uses them to buy the replacement property on your behalf. This prevents you from coming into direct contact with the funds.
Deadline for Identifying Properties
Once you close the transfer of the sold property (relinquished property), you’ll have 45 days to identify a property to buy (replacement property). This time period includes weekends and holidays and it must be observed with no exceptions. If you were to exceed the timeline, the exchange would be considered null and capital gains tax would be imposed.
When identifying properties for purchase, real estate investors can identify up to three properties without considering their fair market value. An investor may only identify more than three properties provided that their aggregate fair market value does not exceed 200% of the sold property.
These rules can however be exceeded if the investor purchases a property with a fair market value of at least 95% of the aggregate of all the identified properties.
Deadline for Closing on Replacement Properties
After identifying and selecting a replacement property, an investor will have 180 days to close on that particular property. You should note that the period for identifying a property and the period for closing on the purchase run concurrently. This means that you’ll need to close on a new property within 180 days of relinquishing your old property.
Due to the strict timelines, investors are advised to schedule the closing on the replacement property before the 180-day period lapses. This transaction will be done by a qualified intermediary to prevent the investor from receiving the funds from the sold property. After closing on the replacement property, the intermediary then transfers it to the investor.
What is a Reverse 1031 Exchange?
A reverse 1031 exchange is similar to a normal exchange, with a minor distinction. A reverse exchange occurs when an investor purchases a replacement property before relinquishing their property. In such a situation, the 45 and 180-day timelines still apply.
To qualify for a reverse 1031 exchange, you must transfer the new property to an exchange accommodation titleholder. You will then need to identify the property you’d like to exchange within 45 days and close the transaction within 180 days. As with a normal 1031 exchange, the 180-day period begins on the date you closed on the replacement property.
A 1031 exchange is a powerful tool that encourages reinvestment, which you can utilize to expand your portfolio. Knowledgeable real estate investors utilize this provision to acquire replacement properties that provide a better return on investment. However, to successfully conduct a 1031 exchange, it is vital that you follow the specified provisions.
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