Maybe you have heard of a 1031 Exchange and then thought that this “program” is only something for rich folks. Well, think again – a 1031 Exchange might be a great option for your to save some of your hard earned cash.*
What is it a 1031 Exchange?
A 1031 is the swap of a business or investment asset for another without triggering capital gains if ALL proceeds are re-invested into the new qualifying asset within the requirements established by the IRS. You are basically rolling your investment from one to the next, hopefully, better investment. As long as you do not cash out and re-invest within the 1031 you can grow your assets tax deferred.* There is also no limit how many times you can purchase a home tax deferred. I like the comparison of a 1031 exchange basically creating an IOU to the IRS. “I owe you” money as soon as I sell and realize my gain.
What qualifies for a 1031 Exchange?
There are many kind of investments qualify for this special swap, however, for the sake of this article I will elaborate solely on Real-Estate Exchanges.
What is like kind?
You’ll be surprised to see what actually can be exchanged. All listed below under “YES” are deemed to be “like-kind” to each other and qualify as a like kind exchange. You can “mix and match” those. All property on the left under NO for an Exchange therefore do not qualify:
|Fee Interest (ownership in real property house/land)||Not your personal property|
|Fractional (tenancy in common) interest||Land under development for resale|
|Leasehold interest, 30 plus lease||Construction or flix/flips for resale|
|Easements for conservation||Property purchased or held for resale|
|Easements for right of way||Inventory property|
|Water rights||Corporation common stock|
|Mineral rights||Partnership interests|
|Oil & Gas interests||LLC membership interests|
|Transferrable Development rights||Bonds, Notes|
|Mutual Irrigation Ditch Stock|
I have to buy a property or right more expensive than what I have
Not quite true. There is a bit more detail to it, but you only have to buy a more expensive house if you want to defer ALL your capital gains taxes. Remember if you buy a less expensive property, you still get some tax benefits.
In detail: The new property you purchase has to be the same amount or greater than your Net Selling Price (NSP=Contract Price-Title Fees/Realtor Commissions).
You cannot use your primary or secondary residence for an exchange
That said, if you have used any part of your home as a business there is a way to possible use THAT particular part as a 1031 exchange. This may be your office (s) or your garage(s). See the list above in the table under YES for qualifying exchange objects.
You don’t have to panic to find a replacement property
You have a total of 180 days to close on another, a replacement property. That’s plenty, right? Of those 18o days you’ll have 45 days in the beginning to find 3 possible contenders for your replacement property ( or 2 other replacement strategies).
If it is a great concern for you that you might not be able to secure a replacement property in time, then consider a “Reverse Exchange.” This is great in fast sellers markets, where you KNOW you won’t have a problem to sell your home, but securing a new home seems much more daunting. Reverse Exchanges are a bit more expensive, but peace of mind might be worth it to you.
I have land that I want to build on
There is an opportunity that you might want to explore and this particular exchange is called “build-to suit or property improvement exchange.” If you found the perfect piece of land and would like to build on it, you may do this under this particular exchange. There are provisions that can be put into place under 1031 that would allow you to complete construction, as long as construction is finished within 180 days from the sales date of within the 180-day window for an exchange. Funds needed for construction may be included into the value of your new property. Remember that this is only for investment property and not to be used for your primary residence.
Found a great deal on a house that needs a lot of improvement? A property improvement exchange could work for this instance as well.
The exchange will be too hard
Not really: If you decide to do a 1031 exchange, you’ll have to make sure that your hands never even come close to the sales proceeds. This is why a Qualified Intermediary (QI ) or Exchange Facilitator is contracted to handle all that for you.
Too much trouble for too little $$$
Depending on your taxable income you could pay 15% , 20% or even 28%. If you have made it with your investment through the weak years, and finally gained some ground, you certainly don’t want to be punished for it.
Example: Let’s say you bought a rental 10 years ago for $75,000. Now you want to sell it and it seems you can get $150,000 for it. You are excited until your CPA tells you that you could easily have to pay $15,000 and up in capital gains tax and depreciation recapture. You decide to use a 1031 Exchange, because you found a nicer newer home at a great deal that rents for $1300/mo and you bought a modular home on half an acre that rents for another $700 a month. Now you exchanged your $1000/month rental income into a $2000/month rental income.
Example: You have a piece of land that is not bringing you any income at all – in fact, it costs you money – every year. This year you decided to sell it for $110,000 and instead of paying capital gains tax you are moving forward with a 1031 exchange buying a small rental with a $800 rental income a month. Not bad, right?
Sooner or later I have to pay anyways
Maybe you do, maybe you don’t. Your tax professional will be able to give you precise advise on what will work for you and what not.
- Anytime you withdraw gain (boot) you’ll have to pay taxes, however, there might be years when your overall income is not as high as in other years and you could be burdened with a reduced tax.
- If you never sell and your heirs inherit the property, they will not have to pay any tax on the gain you deferred and they can sell without owing capital gains tax (there might be other taxes due).
Other reasons to Exchange includes:
- Increasing depreciable basis by acquiring property encumbered with a larger debt.
- Acquiring sheltered income by exchanging your unimproved land for improved property.
- Acquiring property without cash, when sales may be impossible.
- Consolidating assets by exchanging many properties for one larger property.
- Receiving nontaxable cash by exchanging and refinancing after and independent of the exchange.
- Diversifying holdings without tax consequence.
Chances are that the 1031 could really work for you! Talk to your CPA first and then to me to get you on the road of more future real estate wealth.
This list is intended to provide a brief overview of the steps involved in an IRC Section 1031 tax deferred exchange and when a qualified intermediary (QI) should be contacted throughout the process. This checklist does not address all issues involved in an exchange. Please read all of the exchange documents prepared by your QI. Remember that your Qualified Intermediary cannot provide tax or legal advice. Investors should always seek the advice of their tax and/or legal advisors regarding their specific situation.
- REVIEW: Review the entire transaction with tax and/or legal advisors.
- CONTACT your QI: Once you have determined that a 1031 is a tax and investment strategy you’d like to pursue, contact a QI to initiate the exchange transaction and to learn about any requirements. You can ask your real estate professional about suggestions for a QI
- SALE CONTRACT: Enter into an “assignable” contract to sell the relinquished property.
- Execute contract with the exchanger’s name and/or assigns, and with language recognizing the exchange, with the other party’s consent.
- EXCHANGE SET-UP: The QI will prepare the exchange documents for the relinquished property sale.
- The original documents will be forwarded to the closing officer who will coordinate the signatures
- Copies of documents are forwarded to the exchanger.
- RELINQUISHED PROPERTY CLOSES: QI is assigned into the transaction as the seller and sale closes
- Pursuant to the assignment agreement and exchange documents, the QI instructs the closing officer to directly deed the relinquished property to the buyer.
- Exchange proceeds are transferred directly to your QI via wire transfer.
- NEW PROPERTY IDENTIFICATION PERIOD: Both the 45-day identification period and exchange period begin. Although it is the sole responsibility of the exchanger to meet all identification rules, some QI’s will forward confirmation of the exchange proceeds received, the timelines for the 45-day identification period and 180-day exchange period (or the date the tax return is due, whichever is earlier) exchange period, the identification requirements and the identification rules.
- NEW PROPERTY IDENTIFIED: Exchanger properly identifies replacement property by midnight of the 45th day
- Specific written identification, signed by the taxpayer, is forwarded to QI.
- Written identification can also be made to a party involved in the exchange transaction who is not a disqualified person. (See the Treasury Regulations for more details on the identification requirements).
- PURCHASE CONTRACT: Enter into an “assignable” contract to purchase replacement property. Execute contract with the exchanger’s name and/or assigns, and with language recognizing the exchange, with the other party’s consent.
- CONTACTQI: After signing the replacement property contract, contact QI.
- EXCHANGE PAPERWORK PREPARED: Most QI’s will prepare the exchange documents for purchase.
- A) The original documents will be forwarded to the closing officer who will coordinate the signatures.
- B) Copies of documents are forwarded to the exchanger.
- REPLACEMENT PROPERTY CLOSES: API is assigned into the transaction and purchase closes.
- Pursuant to the assignment agreement and exchange documents, QI instructs the closing officer to directly deed the replacement property from the seller.
- QI wire transfers exchange proceeds to the closing officer.
- COMPLETION: If all exchange funds are used to acquire the replacement property or properties, and all the exchange requirements are met, the exchange is complete.
*since I am not a CPA, you should talk to your tax professional
Infographic images via 1031Gateway.com others by Susanna Haynie