When it comes to maximizing the potential of your rental investment property, using a 1031 exchange to swap it for another property may be a viable solution. Discover what a 1031 exchange is, learn how to perform one, explore the various types, and familiarize yourself with the process rules.
What is a 1031 Exchange?
A 1031 exchange is a real estate investment strategy where you swap out one property for another. Standard swaps are taxable, but Section 1031 changes your property without the Internal Revenue Service (IRS) considering it a capital gains tax. Therefore, it allows the investment to grow unfettered and tax deferred. There is no strict limit on how many times you can perform a 1031 exchange, so long as the properties qualify. A 1031 exchange is known as a Starker exchange, like-kind exchange, or Section 1031.
Who Qualifies for a 1031 Exchange?
Investors shouldn’t face too many hurdles to meet the qualifications for a 1031 exchange, as the process is relatively easy. Under Section 1031, the following qualify:
- C corporations
- S corporations
- General and limited partnerships
- Limited liability companies (LLCs)
- Trusts
- Individual and private investors
- Other taxpayers
How to Perform a 1031 Exchange in 3 Steps
1. Identify the eligible property
To identify whether your property is eligible for a 1031 exchange, ensure it is “like-kind”. A property is “like-kind” when it is replacing another similar property. The IRS generally considers real estate properties like-kind regardless of their quality or improvements. For example, a boutique apartment building can be exchanged for a large condominium, office building, or even vacant land.
2. Select a qualified intermediary
After selecting your eligible property, you should work with a qualified intermediary. These specialized real estate professionals, also called exchange facilitators, manage the 1031 exchange process and hold your money in an escrow account until the exchange concludes. Shop around for the exchange facilitator that best meets your needs, someone who can save you money, meet critical deadlines, and provide immediate tax benefits.
3. Report your transaction to the IRS
By law, you must report 1031 exchanges to the IRS by submitting a Form 8824 document and your tax returns for the year you performed the exchange. The form asks that you provide the following information:
- Property descriptions
- Property identification and transfer dates
- Relationship between both parties of the exchange
- Value of the “like-kind” properties
- Adjusted basis (how the property’s book value changed due to Section 1031)
- Assumed or relinquished liabilities
Note: Have a real estate agent or tax professional verify your forms to ensure accuracy. The IRS may penalize or fine you if they believe there is intentionally falsified information.
Types of 1031 Exchanges
Choosing the right 1031 exchange is essential for the financial viability of your investment. There are several types you can choose from, including:
Reverse exchange
A reverse exchange, also called a forward exchange, allows you to purchase a new property before you sell your current one. This transaction is particularly beneficial in a seller’s market when you may need to close on a property fast or choose between competing offers. To qualify for this process, you must:
- Transfer the new investment property to an exchange accommodation titleholder (qualified intermediary).
- Find a property you can exchange within 45 days.
- Finalize the exchange within 180 days after buying the replacement property.
Deferred exchange
A deferred exchange allows you to discard your property and acquire one or more like-kind replacement properties. However, you cannot sell one property to use the proceeds to buy another (as this is a taxable transaction). The exchange depends on the properties being mutually dependent during the integrated transaction (purchasing two or more distinct properties).
Built-to-suit-exchange
A built-to-suit exchange (or construction/improvement exchange) allows you to use the proceeds from selling your old property to purchase and renovate the replacement property. The only requirement is you must complete the renovations or improvements within 180 days.
Drop and swap exchange
In a drop-and-swap exchange, some partners want to make a 1031 exchange, while a smaller group of dissenting partners do not. The exiting partners are paid for their share in the property (usually as a percentage of the transaction). The exiting partners must pay taxes on their profits, while the other group’s proceeds go to a qualified intermediary.
Tenancy-in-common property exchange
The tenancy-in-common property exchange allows you to have part ownership in a large property, along with one to 34 other individual investors. It’s particularly beneficial for smaller investors because it enables them to participate in big transactions that otherwise would have been inaccessible. While each investor owns only a small piece of the property, they have the same rights as a single owner.
Delayed exchange
A delayed exchange is a flexible and popular option because it provides you with 180 days to buy a replacement property. If you sell your property before purchasing a replacement, your qualified intermediary gets the sale proceeds. Once you find a replacement property, the qualified intermediary transfers the money to your closing agent to complete the purchase.
What Can You Use a 1031 Exchange For?
A like-kind exchange is a versatile investing tool, helping you meet your unique investment endeavors. Here are some of the most common ways you can use a 1031 exchange:
Swap residences
You cannot move in immediately when using a 1031 exchange to swap your current property for a second or principal residence to call home. The IRS has a safe harbor ordinance stating it will not challenge if a replacement home qualifies as an investment property for a 1031 exchange. To satisfy the safe harbor rules, there are two requirements you must fulfill:
- You have two 12-month periods after the transaction to rent the property (for a fair price) to a tenant for at least 14 days.
- You must limit your personal use of the property to no more than 14 days or 10 percent of the days within the 12-month period that your occupant is renting it.
Estate planning
Writing a will is an integral part of estate planning because it informs others about what to do with a property owner’s investment once they pass away. While a 1031 exchange defers taxes for a while, you eventually must pay a massive bill once the deferral ends. However, tax liabilities end at casualty, meaning a property owner who passes before they sell the 1031 exchanged property can spare their heirs from paying the taxes. They inherit the investment at its current market value.
Vacation homes
If you own a vacation home but want to turn it into a rental property or even a retirement home, the 1031 provision is a viable solution. However, you must cease personal use of the vacation home and rent it to a tenant for six to 12 months. Once you meet those requirements, you can exchange it for a new property. Ensure you already have tenants when offering your vacation home for a rental property; otherwise, it would not qualify for a 1031 exchange.
Depreciable properties
Depreciable properties are homes that have suffered from substantial wear and tear over time (e.g., decaying historical homes or neglected dwellings). Exchanging a depreciable investment triggers depreciation recapture, a profit taxed as a standard income.
Investors can pay fewer taxes on a depreciating property by deducting the deterioration costs. The IRS usually takes some of the deductions and factors them into your taxable income (making it more costly). However, Section 1031 not only delays this event, but it rolls over your previous depreciation values to the new property.
1031 Exchange Rules
While like-kind changes may be an easy way to defer taxes and maximize your gains, there are three types of rules you must adhere to for your 1031 exchange to be legitimate.
Property rules
- Like-kind rule: All involved properties must be like-kind (similar enough) or of equal or greater value. Most real estate is like-kind to any other real estate, so long as they are in the United States.
- Similar rule: All involved properties must be similar in function or nature. For example, you can exchange an apartment complex for a rental home or even a vacant lot.
- Holding money rule: At no point during the exchange can you hold on to the gains you made from the sale. A qualified intermediary must hold your money in escrow; otherwise, it will be taxable.
Time rules
- 45-day rule: You have 45 days after selling your property to find a viable replacement. You must have this transaction in writing and disclose it to your qualified intermediary or seller.
- 180-day rule: You must close on the new investment property within 180 days of closing on the old/relinquished property or after your tax return due date, whichever solution occurs sooner.
Value rules
- Three-property rule: You can identify three properties as potential investments no matter their current market value.
- 95% rule: There is no limit on how many properties you can identify as investments so long as the property you acquire is valued at 95% or more of their total.
- 200% rule: You can identify as many replacement properties as you want if their cumulative value does not exceed 200% of the sold property’s value.
1031 Exchange Tax Implications
Once your qualified intermediary acquires the new investment, you might have some money left over, referred to as boot. Boot cash is taxable as part of sale proceeds (capital gains). You must also consider loans and debts attached to the old and replacement properties.
For example, if the mortgage on your old property is $200,000 and the mortgage on your replacement property is $190,000, then you’ve made a $10,000 gain. That liability difference is taxable as boot income. You can also get taxed on selling your old property, even if the sale falls through.
Avoid 1031 Exchange Schemes
Like any real estate investment process, 1031 exchanges are vulnerable to schemes. Be careful not to fall prey to people illegally using like-kind exchanges. These individuals, in most cases, are not qualified tax professionals.
For example, a scammer might try to convince you to exchange a vacation home, which is not qualified under Section 1031 (if renters do not occupy it). Exercise caution if they refer to it as a “tax-deferred” or “tax-free” exchange. Another red flag is if they suggest you claim an exchange, knowing they already took the money made from the property sale.
Note: Before going through any of these exchanges, consult an IRS professional for additional assistance.
Frequently Asked Questions
What is an example of a 1031 exchange?
You own an apartment building worth five million dollars, doubling what you paid for it three years ago. Eventually, you want to invest in a luxury condominium worth six million dollars. With Section 1031, you can sell your apartment building, defer the capital gains, and use the proceeds or extra money to invest in the luxury condominium without any immediate tax liabilities
How long must you hold a 1031 property?
While there is no exact holding period (amount of time you own a property before selling it) for 1031 exchanges, you should try to hold it for at least one or two years. If you convert the new property into a primary residence, hold it for at least five years.
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