1031 exchanges can be a complicated and complex transaction. We want to clarify the information on this valuable type of real estate transaction so that you can maximize your investments and take advantage of the tax savings associated with 1031 exchanges.
In order to best understand how to use this strategy to your advantage, you must first understand what it is and why an investor would want to use it.
What Is A 1031 Exchange?
A 1031 exchange is when you transfer the equity in one property into another of equal or greater value. You could also transfer the equity into several properties as long as they are of equal or lesser value.
This is a very common strategy for real estate investors. It is a way for them to transfer their equity without having to pay taxes. Usually when an investment property is sold, taxes are paid. With a 1031 exchange, taxes are not paid and are deferred. It is important to realize that this does not mean that the transaction is tax -free. It simply means that the taxes on the gain are due at a future date.
Since you are deferring the taxes, you have more money available to invest. It is a great strategy to get the most out of a property if you are planning on selling it.
Aside from the benefits of deferring taxes, exchanges have other important benefits to note. First, they allow an investor to reallocate their portfolio. This can be really important if you notice that a change in the marketplace is about to occur. You can modify your portfolio by moving your equity from a property(ies) to other properties that are better positioned for the changes in the marketplace.
Another major benefit of this is that if you have taken the depreciation tax write-off on your properties that are being exchanged, the exchange allows you to recapture the depreciation.
The reason that it is called a 1031 exchange is because that is the portion of the IRS tax code that contains the guidelines for how exchanges must work in order to qualify for the tax-deferred status. In order for the property to qualify for the exchange, there are a lot of rules that you must follow. As an example of how the rules work, here are a few that you must follow:
- The proceeds must go through a qualified intermediary.
- You have 45 days from the time of selling the property to identify potential properties to purchase with the proceeds of the sale. This is called the identification period.
- You have 180 days to finalize the purchase and have the funds reinvested. This time period is known as the exchange period.
An investor owns a single family home worth $150,000. The investor decides to sell the home and purchase a duplex. The duplex has a value of $250,000. The investor has $70,000 equity in the single family home that they want to transfer tax-free to the duplex.
Single Family Home Value: $150,000
Loan on Home: $80,000
Equity in Home: $70,000
Duplex Value: $250,000
Down Payment on Duplex: $70,000
New Loan on Duplex: $180,000
The investor was able to purchase a new investment property that was of greater value. The equity was transferred from one property to the other without having to pay taxes on it. The tax was deferred because all of the profits were reinvested into the new property.
Let’s say that the investor were to only put $60,000 down on the duplex and wanted to keep $10,000. The $10,000 would then be taxed because a gain has been realized. Any money that is not reinvested into a property of equal or greater value would be taxable income.
Types of Exchanges
Another reason why these deals can be very complex is that the exchange can take place in several ways.
In a simultaneous exchange, the sale of the property and the purchase of the replacement property occur at the same time.
A delayed exchange tends to be the most common type of all the exchanges. This is when there is a gap in time from the transfer of the sold property and the purchase of the new property. You need to know that there are strict guidelines with the time limits that are allowed and if you do not adhere to those timelines the transaction will be subject to tax consequences.
A reverse exchange is when you acquire the new property before selling the property that you are taking the equity from. There are also important guidelines to be aware of with this type of exchange.
Build-to-suit exchanges are when you are going to improve or make changes to the property that is being acquired using the proceeds of the exchange as the method of paying for the repairs.
A qualified intermediary (QI) is a third-party to the transaction that takes the funds and uses them for the completion of the exchange. Using a qualified intermediary is a requirement for any kind of 1031 exchange.
Why is it a requirement? Because the tax code states that any time you take possession of the funds, the transaction no longer qualifies for the tax-deferred status. This is a critical point for any investor to understand. If you put the money into your own account (even if it is a separate account to be used only for this purpose), then you are no longer eligible for the 1031 exchange.
While this may be perceived as a negative to this type of transaction, it is actually a good thing for you. Not only does it help you qualify for the exchange, but using a good, competent QI can help you streamline the process and make sure that all qualifications are being met.
Since this type of transaction requires you to follow rules specified in the tax code, it is important to have someone help you safely navigate the 1031 exchange path to ensure legal compliance. If you are interested in doing a 1031 exchange, you must find a QI. They will be able to guide you through the steps of a 1031 exchange and their services will ensure that you qualify for the exchange.