The 411 on The 1031 Exchange

6 things to remember about 1031 exchanges

1031 exchanges allow real estate investors to defer paying capital gains tax when the proceeds from real estate sold are used to buy replacement real estate. The Internal Revenue Code outlines specific steps investors must follow to qualify for a 1031 exchange:

  • Real estate must be used for investment or business purposes
  • Replacement property must be identified within 45 days and purchased within 180 days
  • If the value of the replacement property is less than the relinquished property, the difference is called boot and it is taxable
  • Opportunity Zones created by the Tax Cuts and Jobs Act of 2017 offer new opportunities for tax-deferred investment
  • 1031 exchanges can be used even if there is a mortgage on the property
  • With proper estate planning, accrued deferred capital gains tax can be completely eliminated when real estate is passed on to heirs

1031 exchanges are like having an interest-free loan from the IRS. Instead of paying tax on capital gains, real estate investors can put that extra money to work immediately and enjoy higher current rental income while growing their portfolio faster than would otherwise be possible.

Using a 1031 tax-deferred exchange requires advance planning –
The three primary 1031 exchange rules to follow are:

  1. Replacement property should be of equal or greater value to the one being sold
  2. Replacement property must be identified within 45 days
  3. Replacement property must be purchased within 180 days

Greater or equal value replacement property rule

  • In order to make the most of a 1031 exchange, real estate investors should identify a replacement property—or properties—that are of equal or greater value to the property being sold. There are three ways to do this:

    • Identify up to three properties regardless of their value, or

    • Identify unlimited properties as long as the combined value doesn’t exceed 200% of the property being replaced, or

    • Identify unlimited properties as long as the properties acquired are valued at 95% or more of the property being replaced

Dreaded 45-day identification window and how advance planning pays off

  • Real estate investors need to plan ahead when doing a 1031 exchange. That’s because the IRS only allows 45 days to identify a replacement property for the one that was sold. But in order to get the best price on a replacement property experienced real estate investors don’t wait until their property has been sold before they start looking for a replacement. Imagine calling a real estate broker who has a property listed for sale and telling them there are only two days left to identify a replacement property. The odds of getting a good price on the property are slim to none.

180-day window to purchase replacement property

  • The purchase and closing of the replacement property must occur no later than 180 days from the time the current property was sold. Remember that 180 days is not the same thing as 6 months. The IRS counts each individual day, including weekends and holidays (even federal holidays), to determine the 180-day time frame.

1031 exchanges also work with mortgaged property

  • Real estate with an existing mortgage can also be used for a 1031 exchange. The amount of the mortgage on the replacement property must be the same or greater than the mortgage on the property being sold. If it’s less, the difference in value is treated as boot and it’s taxable.

How the step-up basis can permanently eliminate capital gains tax

  • 1031 exchanges defer—or put off to the future—the payment of accumulated capital gains tax. But what happens when the real estate investor passes away? When real estate is passed on to an heir, the property is revalued—or stepped up to—its fair market value and any deferred capital gains taxes are eliminated. Which only goes to show that the saying, ‘Nothing is sure except death and taxes’ is only partly true!

Five common types of 1031 exchanges

    1. Delayed exchange with one property being sold—or relinquished—and a replacement property (or properties) purchased during the allowed window of time.
    2. Delayed/simultaneous exchange with the replacement property purchased at the same time the current property is sold.
    3. Delayed reverse exchange with the replacement property purchased beforethe current property is relinquished.
    4. Delayed build-to-suit exchange with the current property replaced with a new property built-to-suit the need of the investor.
    5. Delayed/simultaneous build-to-suit exchange with the built-to-suit property purchased before the current property is sold.

    It’s important to note that investors cannot receive proceeds from the sale of a property while a replacement property is being identified and purchased. Instead, funds are held in escrow by a 1031 exchange intermediary—sometimes referred to as an accomodator—until the replacement property is purchased.

    The intermediary cannot be someone who has acted as the exchangor’s agent, such as your employee, lawyer, accountant, banker, broker, or real estate agent. It is best practice however to ask one of these people, often your broker or escrow officer, for a reference for a qualified intermediary for your 1031.

    How the IRS defines a like-kind exchange

    Under Section 1031 of the Internal Revenue Code like-kind exchanges are:

    Real estate investors making like-kind exchanges generally aren’t required to recognize a gain or loss under the Internal Revenue Code, unless they receive other not like-kind property or money, or if the property was held mainly for sale and not for business use.

    Eligible like-kind property types for 1031 exchanges

    According to the Internal Revenue Service, property is like-kind if it’s the same nature or character as the one being replaced, even if the quality is different. The IRS considers real estate property to be like-kind regardless of how the real estate is improved.

    For example, real estate investors can exchange a small apartment building for a larger apartment project, for an office building, or for vacant land.The Tax Cuts and Jobs Act of 2017 eliminated personal and intangible property from being included in tax-deferred exchanges. That includes items such as machinery, equipment, artwork, collectibles, patents and intellectual property.

    However, the Act created an Opportunity Zones incentive to encourage long-term and tax-deferred investments in urban and rural areas with low-incomes. Opportunity zones are in all 50 states, and U.S. Territories such as Puerto Rico and the Virgin Islands.

My take a-ways are to be prepared and have a professional on your side. If you need a referral for an amazing accomodator let me know!

A love for interior design, family and home is something I think I was born with! Home has always my happy place and a place of safety and comfort for my always growing family. I didn’t pursue real estate until later in life, but it’s been a passion for as long as I can remember.
I can sit here and tell you I have strong negotiating skills, local market knowledge, and so forth – and of course, I do – but one thing I want to share with you, the thing that is the most important tool I can provide you in your home sale or purchase is my passion and my love for people.
My focus goes beyond the professionalism, experience and market knowledge, my focus is to facilitate your WHY, selling or buying your WHY is my priority? You need a real estate agent who understands that, and seeks to know the answer to those questions, and all of the other important ones that make buying and selling a reality for you. You don’t need a computer to find your dream house, you need a professional partner who has your best interest at heart from the moment you call to even after we close. I’m doing more than just selling houses, I’m providing you the keys to bring your dreams home.