The U.S. tax code has numerous provisions to make investing (and re-investing) easier for companies and individuals alike. Congress has designed much of the code to encourage people not to keep their money on the sidelines but instead put it back in the economy for growth purposes. The 1031 exchange rules fall very much into this category. Used by countless savvy investors, knowing these rules (and how to apply them) can sometimes mean the difference of hundreds of thousands when it comes time to your tax bill.
Unfortunately, much like many other aspects of the tax code, these rules can feel confusing, and it can be hard to figure out just when one of these exchanges applies. To help demystify this, let’s look at what a 1031 exchange is, what benefits it can have, and the top 10 things you need to know before attempting a 1031 exchange!
1031 Exchange Rules: First, What Is a 1031 Exchange?
Before getting into the intricacies of a 1031 exchange, it’s first worth reviewing what, exactly, this financial maneuver is. The IRS tax code provides the ability to exchange one type of property for another “like-kind” property and not have to pay tax on any gains realized from the sale of the first property
Although section 1031 is generally used to describe real estate deals, it can also apply to other types of property including buildings and land.
Before getting into the intricacies of a 1031 exchange, it’s first worth reviewing what, exactly, this financial maneuver is. The IRS tax code provides the ability to exchange one type of property for another “like-kind” property and not have to pay tax on any gains realized from the sale of the first property.
To give you an example of a 1031 exchange, suppose a real estate investor is looking to sell his 10-unit apartment building. Let’s suppose there was a significant capital appreciation on the apartment building over the past 10 years the investor. When the real estate investor goes to sell, they’ll have to pay a tax on the capital gains when the sale completes. So, in the hypothetical example above, let’s say the real estate investor bought the 10-unit apartment building ten years ago for $1 million, and it sells for $2 million. In that case, typically, the owner would need to pay taxes on the $1 million gain.
The problem with this scenario is that it creates a disincentive for reinvestment. After selling, the owner may reconsider selling when they know they will face a substantial tax bill. At the very least, the large chunk that the government will take will mean that fewer dollars will be available for reinvestment.
Given this, Congress, way back in 1921, carved out a path to let people defer paying taxes on “like-kind exchanges.” Instead of paying taxes every time you sell one property and buy another, the 1031 exchange rules say that you can defer all taxation until you “cash-out” (that is, until you take the cash instead of using that money to buy a new property).
How Do 1031 Exchange Benefit Investors?
Conceptually, a 1031 exchange is simple – you’re merely deferring taxation. However, its effects can be pretty powerful, primarily due to the compounding that can take place.
Consider the following example.
Jim is looking to buy a rental property with $40k in cash ($200k in value). Over time Jim’s property appreciates to $280,000 in value. Jim is looking to sell his property and his $80K capital gains are subject to a 15% tax from the government. If Jim decides to perform a 1031 exchange and reinvest his capital into a new real estate property, Jim can save $12,000 in capital gains taxes.
As you can see, this example is just for one single-family property; however, when 1031 exchanges are performed on large apartment buildings that accumulate millions in capital gains, you can imagine the tens of thousands of savings that can incur for investors!
1031 Exchange Rules: The 10 Things to Know
By now, it should be relatively self-evident how powerful deferring taxation can be to wealth generation. However, like almost anything in the U.S. tax code, initiating the exchange isn’t as simple as selling one property and buying another. There are ten things you need to know before you take advantage of the 1031 exchange rules.
1. The 1031 Exchange Rules Require Replacement Property Identification Within 45 Days
Unfortunately, with a 1031 exchange, you don’t get an unlimited amount of time to complete the transaction. Quite the opposite, actually. The rules say that anyone looking to take advantage of this must identify a replacement property within 45 days after selling the original one. This timeline is relatively aggressive, so you’ll need to start looking for properties before you sell so that way you’ll have one lined up in time!
2. And the Purchase Must Happen Within 180 Days
Additionally, you must complete the purchase within 180 days of the sale of the old property. Weekends, holidays, and everything count in this, so you’ll want to make sure you don’t have to wait long to close on your new property!
3. The New Property Must Be of Greater or Equal Value
The replacement property that you acquire should be of greater or equal value to the property you sold. Therefore, you cannot use a 1031 exchange to “downgrade.” You’ll need to buy a higher valued property when performing a 1031 exchange.
4. Your New Mortgage Must Be of a Greater or Equal Amount
This aspect of the 1031 exchange can sometimes trip people up. You cannot use a 1031 exchange to “eliminate” your mortgage.
Whatever the mortgage balance was at the time of sale is, the mortgage on your new property will have to equal or exceed for a 1031 exchange to be fully deferred.
5. It’s Possible to Eliminate Capital Gains Tax
If you hold on to 1031 properties indefinitely, you’ll never pay capital gains tax. Then, when your heirs take those 1031 properties over, the IRS re-evaluates the cost-basis to be their value at the time of your death. But, your heirs are not liable for the capital gains taxes! So, you don’t pay them, and your heirs don’t either. However, 1031 is not “grandfathered,” so your heirs will need to pay tax on any capital gains after your death.
6. It is Easiest to Use a Qualified Intermediary
To facilitate a 1031 exchange, it is easiest to use a “qualified intermediary” as per IRS regulations. This qualified intermediary will perform the following steps to ensure your transaction is compliant:
- Acquire property from you and transfer it to the buyer.
- Hold the funds in escrow until you identify the replacement property (45 days!)
- Acquire the replacement property from the seller.
- Transfer that new property to you.
As you might imagine, the qualified intermediary will charge a fee for this service. However, given the tax-deferral benefits, it’s often worth it to go this route rather than pay the taxes.
7. 1031 Exchange Rules State that Like-Kind Properties Do Not Include International Real Estate
If you have your eyes on international real estate, you should know that you cannot use this tax code section for properties outside of the United States. So, you can’t trade your asset in the U.S. for investment in Canada, or vice-versa, for example. However, you can buy a property within any U.S. state and have it qualified for a 1031 exchange.
8. You Can Exchange Between Different Types of Property
However, even though the IRS code disallows international transactions, it’s relatively liberal on what does qualify otherwise. There’s no requirement that you trade a house for a house, for example. You can change a home for vacant land, land for an apartment building, or an apartment building for a house. As far as the IRS is concerned, it’s all like-kind,
The only exception is that improvements conveyed without land are not of like-kind to land. So you can’t exchange building improvements you made on land you don’t own for land that you do own.
9. You Must File Form 8824 with Your Taxes
As per IRS rules, you must file Form 8824, Like-Kind Exchanges, with your taxes each year you do one of these transactions. Although not particularly complex, it’s probably best to have a qualified accountant or tax lawyer prepare it or check it for you so that you are not inadvertently liable for any taxes.
10. You Can Also Defer Taxes Through Opportunity Zones
Last but not least, the 1031 exchange rules are no longer the only way to defer capital gains tax. The 2017 Tax Cuts and Jobs Act created various Opportunity Zones in all 50 states to encourage investment in low-income communities. These Opportunity Zones also permit the deferral of capital gains taxes but tend to be a little more complex to manage and initiate than a 1031 exchange. Still, if you are interested in another way to invest in real estate and defer taxes, this is the other method to do so!
1031 Exchange Rules: Tax Deferral Creates Powerful Opportunities
The ability to defer taxes can create powerful opportunities for investors. While the 1031 exchange rules might be a little nuanced, the result is ultimately worth it as the ability to defer or possibly eliminate capital gains is a powerful wealth-building tool.
If you are investing in real estate and are looking to exchange one investment for another, please look into whether or not a 1031 exchange would work for you!