Summary/TL;DR
A 1031 Exchange is a method of capital gains tax deferral involving a “like-kind” exchange of real estate. Success in a 1031 Exchange depends on compliance with a strict set of rules, such as using a Qualified Intermediary to facilitate the exchange, identifying potential replacement properties within 45 days of the sale of the relinquished property, and purchasing a replacement property within 180 days of the exchange. Due to these touchy rules, a 1031 Exchange should only be attempted alongside a team of competent professionals.
Introduction
Selling an investment property that’s highly appreciated or has had a lot of depreciation taken against it can incur large tax liabilities for its owner. Fortunately, real estate is unique in that it allows investors to defer capital gains incurred on the sale of a property through a process called a 1031 Exchange.
In today’s post, we’ll discuss the anatomy of a 1031 Exchange and how it can help you save thousands in taxes when you sell an investment property.
1031 Exchange Basics
A 1031 Exchange is a method of capital gains tax deferral involving a “like-kind” exchange of real estate. The concept of a 1031 exchange is simple to understand - you sell a business or investment property and use the proceeds to purchase another business or investment property. As long as some strict rules discussed below are followed, no taxes will be owed on the sale of the relinquished property!
In practice, 1031 Exchanges are nuanced and require strict adherence to the code of law. There are three main rules to keep in mind:
The exchange must be facilitated by a Qualified Intermediary (QI) who holds the funds in escrow on your behalf while the exchange takes place. At no point in time may you possess the funds from the sale of the relinquished property! The funds must be wired directly to your QI upon closing or else the exchange is invalid.
You must identify, in writing, a list of potential replacement properties to purchase within 45 days of the closing of your relinquished property. This list must be shared with your QI.
You must purchase one of the properties on your list in Step 2 no later than the earlier of 180 days after the closing of your first property or on the due date of your next tax return.
The replacement property can be more or less valuable than the relinquished property. If it is more valuable, then you may secure a loan to finance the difference between what you’re purchasing the new property for and what you sold the old property for. If it is less valuable, then you will owe capital gains tax on whatever portion of the sale proceeds was not used to purchase the replacement property, although more than one replacement property may be purchased to avoid this. Finally, the seller of the relinquished property must be identical to the buyer of the replacement property. In other words, you cannot sell a property in your personal name and then buy a replacement property in the name of your LLC, or vice versa.
Types of 1031 Exchanges
There are numerous types of 1031 Exchanges, each with their own peculiarities that should only be navigated alongside your QI and CPA. The most common types are below.
Deferred Exchanges
This is likely the most common type of exchange and proceeds as described in the outline of a 1031 Exchange above. A list of replacement property is identified within 45 days of the sale of the relinquished property and is purchased within 180 days of the sale.
Simultaneous Exchanges
In a simultaneous exchange, the sale of the relinquished property and the purchase of the replacement property occur on the same day.
Reverse Exchanges
In a reverse exchange, the replacement property is purchased before the sale of the relinquished property. These are more complex than the other exchanges listed here and require specialized execution through a competent qualified intermediary.
Don’t Try This At Home
The best way to mess up a 1031 Exchange is to try it on your own. If you plan to sell a property, discuss it with your financial planner and CPA and meet with a qualified intermediary ahead of time to familiarize yourself with the requirements and process. Today’s post has only touched on the basics of the 1031 Exchange, but there are plenty of nuanced details that could enter the picture in your personalized circumstances.
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