July 23, 20238-minute read
Author: Melissa Brock
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For real estate investors, taxes are just part of the deal. But 1031 exchanges, named after Section 1031 of the IRS tax code, allow you to sidestep capital gains tax in some cases. We’ve put together some tips about 1031 exchanges as well as some of the most important rules to follow.
What Is A 1031 Exchange?
A 1031 exchange is a real estate investing tool that allows investors to exchange an investment property for another property of equal or higher value and defer paying capital gains tax on the profit they make from the sale. This method is popular with investors looking to upgrade properties without paying taxes on proceeds. A 1031 exchange – also known as a “like-kind” or Starker exchange – applies to real property, which primarily refers to buildings and land.
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How Does A 1031 Exchange Work?
You can postpone paying capital gains taxes by selling a property and putting the proceeds toward a “like-kind” property, which is a property that is similar in nature and value. If you don’t receive proceeds from the sale, there’s no income to tax. In other words, you gain no profit from the sale.
What Is An Example Of A 1031 Exchange?
Investors can grow their real estate investment portfolios faster by taking advantage of a 1031 exchange. Instead of paying taxes on their proceeds, they keep all their money and reinvest it into a new property. Let’s say the value of an investor’s rental property has grown, and they want to reinvest in another property. To maximize their investment and defer capital gains tax, they can initiate a 1031 exchange. The investor uses the proceeds from the sale of the original rental property to acquire a new rental property. Timing can be tricky when completing a 1031 exchange. The IRS requires investors to identify a replacement property within 45 days of the sale and complete the purchase within 180 days. This relatively short time frame can lead to pressure and competition, especially in high-demand markets. To avoid issues, investors often work with real estate agents and intermediaries to help execute 1031 exchanges. The real estate agent can help find replacement properties while intermediaries can manage the exchange process and guide investors on IRS regulations.
How To Make A 1031 Exchange
Now that you know how a 1031 exchange works, let’s go over an example of a 1031 exchange. The initial step is to determine which property you want to sell and which property you want to exchange. The property you’re selling and the property you’re buying must be “like-kind,” which means they’re similar, though they may not be the same quality or grade. Next, you must work with a qualified intermediary, also known as an exchange facilitator, to handle the 1031 exchange transaction. The qualified intermediary holds your sale proceeds in escrow until the exchange is complete. Choose your qualified intermediary with care so you don’t lose money, miss key deadlines or end up paying taxes. Lastly, you must report the exchange to the IRS by filing Form 8824 with your tax return. You’ll describe the properties involved in the exchange, provide a timeline, explain who was involved in the process and catalog all the money involved. Both the relinquished property you sell and the replacement property you buy must meet certain requirements. The property you want to sell is the relinquished property – sometimes known as Phase 1 or downleg – gets exchanged for a similar property in a 1031 exchange. The property you want to exchange is the replacement property is the “like-kind” property purchased with the proceeds from the sale of the relinquished property. This is also sometimes referred to as the upleg of the exchange.1. Identify The Property You Want To Sell and Buy
2. Choose A Qualified Intermediary
3. Tell The IRS About Your Transaction
Relinquished Property
Replacement Property
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What Is A Qualified Intermediary?
A qualified intermediary is a person or company that sells a property on your behalf, buys the replacement asset and transfers the deed to you. A qualified intermediary’s job is to:
Choosing The Right Qualified Intermediary
It’s important to choose the right qualified intermediary. Confirm that the qualified intermediary you’re considering offers:
When To Use A 1031 Exchange
There are many reasons to use a 1031 exchange. You may want to:
1031 Exchange Requirements And Timeline
Let’s discuss the rules and regulations of a 1031 exchange, including property and time requirements. The property you exchange must meet certain requirements: Finally, Section 1031 doesn’t apply to these types of exchanges: The 180-day time limit for a 1031 tax exchange is a strict deadline. If you don’t meet it, you may be subject to capital gains tax on the profit from the sale of your property.Property Requirements
1031 Timeline Requirements
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Types Of 1031 Exchanges
You may want to look into three types of tax-deferred exchanges: delayed exchanges, reverse exchanges and build-to-suit exchanges. A delayed exchange is the most common exchange format. It gives investors the flexibility to purchase a replacement property within 180 days of selling a relinquished property. If the relinquished property is sold before you acquire the replacement property, the sale proceeds go to your qualified intermediary. The qualified intermediary keeps the money until you purchase the replacement property, delivering the funds to the closing agent. A reverse exchange is when you close on a replacement property before you close on the sale of the relinquished property. You may want to tap into this option to get a desirable replacement property in a seller’s market, especially if you encounter competing offers or need to close quickly. When you buy the replacement property before selling the relinquished property, the property must be transferred through an exchange accommodation titleholder – the qualified intermediary. A build-to-suit exchange, also known as a construction exchange or improvement exchange, allows investors to use the deferred tax dollars from the sale of their investment property toward renovations on the replacement property. The improvements must be completed within 180 days.Delayed Exchange
Reverse Exchange
Build-To-Suit Exchange
Tax Implications Of A 1031 Exchange
You may encounter some tax implications with a 1031 exchange, including:
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1031 Exchange FAQs
Let’s address some common questions to help explain when and how to take advantage of a 1031 exchange. If you’ve claimed tax deductions for depreciation on an investment property, you may need to pay taxes on some of the profit you make when you sell. The IRS “recaptures” the taxes you would have paid if you hadn’t taken depreciation deductions. Take advantage of a 1031 exchange to avoid depreciation recapture on proceeds from a sale. Defer taxes by reinvesting the entire amount of your proceeds into the purchase of a replacement property. If you need the cash from the sale of an investment property for anything other than the central purpose of a 1031 exchange, which is to reinvest your sale proceeds in a “like-kind” investment property – such as paying off debt, making a down payment, etc. – you should reconsider a 1031 exchange. The IRS doesn’t mandate a fixed holding period, but the general recommendation is to hold on to a property for at least 1 year. The IRS taxes capital gains depending on how long or short you held the property. Long-term capital gains are taxed at a lower tax rate. Rental properties, commercial buildings and vacant land qualify for a 1031 exchange. Primary residences and second homes aren’t eligible for 1031 exchanges. What is 1031 exchange depreciation recapture?
When should I not do a 1031 exchange?
How long do I have to hold a 1031 exchange?
Which types of properties qualify for a 1031 exchange?
The Bottom Line
A 1031 exchange can help real estate investors buy more profitable properties, grow their portfolio, defer capital gains tax and continue reinvesting. Because of its strict requirements and deadlines, a 1031 exchange can be a complicated process. It’s important to have a qualified intermediary facilitate the 1031 exchange on your behalf and ensure the transaction complies with IRS guidelines. Investing in real estate takes time and thorough research to navigate its ins and outs. Take the next step on your real estate investment journey and start the mortgage application process with Rocket Mortgage®.
I've got a deep dive into 1031 exchanges ready for you! A 1031 exchange, named after Section 1031 of the IRS tax code, is a tool for real estate investors to defer capital gains tax when swapping one investment property for another of equal or higher value. This allows for property upgrades without incurring immediate taxes on the profit from the sale.
Here's a breakdown of the concepts covered in the article:
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What is a 1031 Exchange? It's a method enabling investors to exchange one investment property for another of equal or higher value and defer capital gains tax on the profit made from the sale. This applies to real property like buildings and land.
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How Does It Work? By reinvesting sale proceeds into a "like-kind" property, investors can defer paying capital gains tax. No proceeds mean no taxable income.
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Example of a 1031 Exchange: Investors reinvest proceeds from the sale of an appreciated property into a new one, avoiding immediate taxes. However, timing is crucial—45 days to identify a replacement property and 180 days to complete the purchase.
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Process: The steps involve identifying the property to sell and buy, working with a qualified intermediary, and reporting the exchange to the IRS using Form 8824.
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Qualified Intermediary: This person or company manages the exchange process, holds sale proceeds, coordinates documentation, and ensures compliance with IRS regulations.
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Choosing the Right Qualified Intermediary: Look for real estate experience, compliance credentials, transparent transactions, and fund security.
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When to Use a 1031 Exchange: It's beneficial for various reasons, such as upgrading to better ROI properties, consolidating properties, or resetting depreciation.
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Requirements and Timeline: Properties must be "like-kind" and meet IRS stipulations. There are strict time frames—45 days to identify, 180 days to close on the replacement property.
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Types of Exchanges: Delayed, Reverse, and Build-to-Suit exchanges offer flexibility in different scenarios.
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Tax Implications: Defer taxes but watch out for "boot" (excess cash), differences in mortgage amounts, and potential tax liabilities from multiple exchanges.
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FAQs: Covers depreciation recapture, when not to do a 1031 exchange, holding period, and property eligibility.
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Bottom Line: 1031 exchanges aid investors in acquiring better properties, deferring taxes, but require adherence to strict guidelines and deadlines.
If you're eyeing a 1031 exchange, meticulous planning, understanding IRS regulations, and working with experienced professionals are crucial for a successful transaction.