A 1031 exchange refers to Section 1031 of the U.S. Internal Revenue Code. A 1031 exchange allows real estate owners or investors to sell a property and then reinvest within a specific time limit to defer or dodge capital gains taxes.
For a successful 1031 exchange to occur, an investor must reinvest the capital from the sale within a 45-day window. Section 1031 allows investors to trade real estate property for a business of like-kind without incurring any tax.
Table Of Contents:
- 1031 exchange ‘like-kind property.’
- Identifying a 1031 exchange property
- Three Property rule
- 200% rule
- 95% rule
- Types of 1031 exchanges
- Simultaneous exchange
- Delayed exchange
- Improvement exchange
- Reverse exchange
- Full tax-deferred exchange
- Partially tax-deferred exchange
- 1031 exchange benefits
- 1031 exchange risks
- The bottom line
1031 exchange ‘like-kind property.’
A like-kind property refers to a broad range of real estate exchangeable properties. These could be residential, commercial, industrial, retail, condos, hotels, etc. An investor can exchange her apartment building for a strip of vacant land or industrial property for a residential.
However, one cannot exchange a commercial property for a stock or bond and a residential property for an artwork. A ‘like-kind’ property is defined in terms of its nature regardless of its grade or value of the assets.
Identifying a 1031 exchange property
It is essential to find a replacement property for the assets sold within the 45-day window and conclude the exchange within the 180 days deadline to complete the exchange. Identifying a suitable replacement within the set time frame can be integral in determining the course of the exchange.
There are three rules used for identification in a 1031 exchange.
Three Property rule:
Up to three different properties are identified within the 45-day window for exchange regardless of their market value.
Unlimited replacement properties are identified as long as their total value together does not exceed 200% of the relinquished property value through the 1031 exchange.
Replacement properties are identified as long as properties valued at 95% of their total value can be acquired before the end of the exchange period.
Types of 1031 exchanges
A like-kind 1031 exchange can vary considerably depending on the nature of the investment. A typical 1031 exchange can be categorized into the following:
Simultaneous exchange occurs when the closing on the relinquished property and replacement property occurs within the same day. It was the oldest and the most prevalent form of 1031 exchange. A 1031 exchange is rarely used today. Most investors find it challenging to find a property owned by someone who wants to exchange their investment property.
Delayed exchange occurs when the closing on the relinquished property and replacement property occurs within the 180 days exchange period.
Improvement exchange allows the replacement property to be renovated and improved. Also referred to as “construction” or “build-to-suit exchange,” this type of exchange is useful when the replacement property is not of equal or greater value than the relinquished investment property. However, all construction and improvement have to be completed within the 180 days exchange period. Finally, the replacement property has to be of equal or greater value at the time of the exchange’s completion.
Reverse exchange occurs when the replacement property is acquired before selling the relinquished property to the exchange party. A replacement property must be identified within the 45-day window of the transfer of property and close the transaction within the 180 days exchange period.
Full tax-deferred exchange
A successful 1031 exchange must satisfy the following conditions:
- The property must be like-kind, i.e., they must be of the same nature even if they differ in quality.
- The property must be held for productive business or investment use and traded for the same purpose.
- The new property to be received in exchange for a relinquished property must be identified within the 45-day window.
- The transfer of the like-kind property must be made within the 180-day period following the transfer of property or the next tax return due date for the transferred property.
Partially tax-deferred exchange
There are situations when a 1031 exchange does not include an exchange of like-kind property. As a result, there cannot be a complete tax-deferred 1031 exchange.
The difference in value between a property and the one being exchanged is called boot. In the absence of an equal exchange of property with the same trade value, the exchange may involve cash payment or personal property from either party.
However, personal property or non-like-kind does qualify for a 1031 exchange. The boot (cash boot) received, on the other hand, falls under the 1031 exchange, but the investor is liable to pay taxes on the boot.
In the presence of a mortgage on both properties, an investor may also use the boot to reduce mortgage liability. If the mortgage on the replacement is less than the mortgage on the property being sold, the party receiving the smaller mortgage and giving up the larger mortgage treats the difference as a cash boot.
1031 exchange benefits
In addition to deferring tax on capital gains, greater purchasing power, and an impressive real estate portfolio, a 1031 exchange can ensure a stable future for the heirs inheriting property.
Not only can one take tax deferment under the 1031 exchange to the grave but pass it down to the heirs who receive it at a higher market value and all deferred tax debt annulled.
1031 exchange risks
Venture into the idea of tax deferment on capital gains can be very appealing. But one can quickly end up feeling weary thanks to specialized and complicated procedures built-in to the trade. Hiring a qualified intermediary (QI) is one way around this problem.
Given the sheer number of QI’s in the market, choosing the right QI in handling and successfully closing your 1031 exchange can be taxing. Similarly, not knowing which 1031 exchange will suit your investment requirements will work against you.
The 1031 exchange deadline is another critical thing to consider. The Internal Revenue Service (IRS) does not grant any extension on a missing 1031 exchange deadline unless it is a matter of grave national emergency.
However, 1031 exchange deadlines are debilitating when investors rush to identify a replacement property within the allotted time frame and end up overpaying or choosing an inappropriate one.
The bottom line
Investing in real estate is a highly tax-advantaged industry and therefore promises to be rewarding for physicians looking to invest in real estate.
The tax deferment on capital gains offered by a 1031 exchange affords many possibilities to boost your investments and diversify your assets.
Working in conjunction with a competent QI can help guide you through the process and successfully complete a 1031 exchange.