As a real estate investor, there are certain rules that you need to follow in order to be compliant with the law. While they can be stringent, there are actually some regulations that you can leverage to make the most of your investment.
One of these rules is known as the “like-kind exchange”, which is formally known as the Internal Revenue Code (IRC) Section 1031 exchange. In a way, this policy allows you to enjoy tax benefits by exchanging one investment property for another.
In this article, you will learn everything you need to know about what is a 1031 real estate exchange and the requirements to be eligible for such a privilege.
What Is a 1031 Real Estate Exchange?
In order to defer your capital gains taxes, you need to reinvest the proceeds from the sale of your property into like-kind property. The IRS defines 1031 exchange property as an investment or business property that is held for productive use in a trade or business.
So, what does this mean for real estate investors like you? Well, it essentially allows you to exchange one investment property for another without having to pay any capital gains taxes on the sale.
However, there are certain requirements that must be met in order for the exchange to be valid. Let’s take a look at these requirements now.
Requirements of a Valid 1031 Exchange
In order for your exchange to be valid and tax-deferred, you need to adhere to the following requirements.
1. The properties must be exchanged in a simultaneous swap.
When you search for 1031 exchange properties for sale, you must also identify the property you want to exchange and complete the purchase within the same time. It’s important to note that you cannot receive any cash or other forms of payment as part of the deal. The whole exchange needs to be a straight swap with no money exchanging hands.
If you do receive any type of payment, then it’s considered a “boot”, and you will have to pay capital gains taxes on it.
Let’s say, for example, that you sell a rental property for $200,000 and use $20,000 of your own money to make improvements on the new property. In this case, the $20,000 is considered a boot, and you’ll be taxed on it.
2. The properties must be of like kind.
As we mentioned earlier, the properties must be investment or business properties that are held for productive use in a trade or business or for investment.
So, what does this mean in practice? Well, it essentially means that you can exchange any type of your property for 1031 exchange properties for sale as long as they’re both used for investment purposes.
For example, you could exchange a rental commercial property for a commercial space, an office building for a retail store, or even a warehouse for an industrial complex.
The only exception to this rule is if you’re exchanging property located in the US for foreign real estate. In this case, the properties don’t have to be of like kind, but they still need to be used for investment purposes.
Moreover, you cannot exchange property for personal use. If you’re thinking of exchanging a property you live in for an investment property, then you won’t be able to do it tax-deferred. You would first need to move out of the property and rent it out before you can exchange it.
Otherwise, if you exchange a primary residence for another primary residence, then it’s considered a non-taxable event.
3. You must identify the property you plan to exchange within 45 days.
This is probably the most important requirement of a valid exchange. You must identify the property you want to exchange for within 45 days of selling your original property. You can do this by providing the name and address of the property to your broker, real estate agent, or attorney.
It’s important to note that you cannot identify more than three properties. If you identify more than three, then the identification is void, and you will not be able to complete a tax-deferred exchange.
Moreover, if you’re unable to find some replacement 1031 commercial properties within the 45-day window, then you have two options.
- You can still complete the exchange, but you will have to pay capital gains taxes on the sale of your original property.
- You can cancel the exchange entirely and forgo the tax deferral.
4. You must complete the exchange within 180 days or before your tax return is due (whichever is earlier).
Apart from identifying the properties within a 45-day period, you must complete the purchase of your replacement property within 180 days of selling your original property. If you’re unable to do this, then the exchange will be void, and you will have to pay capital gains taxes on the sale of your original property.
Moreover, if you don’t complete the purchase of the replacement property by the time your tax return is due (usually April 15th), then you will have to file an extension.
5. You must use a qualified intermediary (QI) for the exchange.
Last but not least, you must use a qualified intermediary (QI) to facilitate the exchange. A QI, who is also referred to as an accommodator or facilitator, is an independent third party that holds the proceeds from the sale of your original property and uses them to purchase the replacement property on your behalf.
The QI cannot be a relative, broker, real estate agent, or attorney of either party to the exchange.
Types of Properties That Are Considered “Like-Kind”
Generally speaking, most investment and business real estate properties will qualify as like-kind property. When checking 1031 exchange property listings, you’ll often see these types of properties.
- Residential rental properties
- Commercial rental properties
- Vacant lands
- Office buildings
- Retail stores
- Industrial complexes
The only types of properties that are not considered like-kind are personal-use properties. These include primary residences, second homes, and vacation homes.
Benefits of 1031 Exchanges
Aside from being able to defer paying capital gains taxes on the sale of your property, there are other benefits of buying and selling like-kind properties.
Depreciation Recapture Tax Deferral
Depreciation recapture is a tax on the portion of your property’s value that was created by depreciation deductions taken over the years. When you sell an investment property, you’re required to pay this tax.
However, if you exchange it for another investment property, then you can defer paying this tax until you sell the replacement property.
Ability to Exchange Properties of Unequal Value
Another benefit of a like-kind exchange is that you can exchange properties of unequal value. For instance, you sell a rental property for $600,000 and use the proceeds to purchase two rental properties worth $300,000 each. In this case, you would only defer paying taxes on the $600,000 gain from the sale of your original property.
You would not have to pay any taxes on the purchase of the two replacement properties since they were purchased with like-kind property.
Trading a 1031 exchange commercial property offers you the ability to diversify your portfolio without having to pay capital gains taxes. For instance, let’s say you own a rental property in New York that’s generating a good return. However, you’re concerned about the high cost of living in the city and want to diversify your portfolio by investing in a different market.
By completing a like-kind exchange, you can sell your rental property in New York and use the proceeds to purchase a rental property in another state. This would allow you to diversify your portfolio without having to pay any capital gains taxes on the sale of your original property.
Increased Buying Power
As previously implied, you can use the proceeds from the sale of your property to purchase multiple replacement properties. For example, you sell a rental property for $200,000 and use the proceeds to purchase two rental properties worth $100,000 each. In this case, you would have effectively doubled your investment without having to pay any capital gains taxes.
When you play it carefully, a like-kind exchange can offer you significant advantages that will help you grow your investment portfolio. That is why you should know what is a 1031 real estate exchange and do other due diligence before taking the plunge. With the tips provided in this article, you should be well on your way to success in this type of trade.
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