Throwing around terms related to the tax code typically puts the average taxpayer to sleep, but if you invest in real estate,  the topic of 1031 exchanges might be one to wake up for. While it’s not exactly a discussion for the dinner table, it has definitely caused a stir with seasoned Realtors and investors alike.  Using this strategy can save you a ton on taxes, but it comes with a list of rules and qualifications. Let’s take a look at what it’s used for, 1031 exchange rules to watch out for, and if your properties might qualify.  

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What is a 1031 Exchange?

A 1031 exchange gets its name from,  you guessed it, IRS Section 1031 of the tax code.  It’s also known as a like-kind exchange or Starker exchange.  While it might seem complex, the concept is fairly simple: Take proceeds from the sale of an investment property and reinvest in a like-kind investment to defer capital gains tax. There is no restriction on how many times you can use a 1031 to roll gain from property to property, hopefully paying one tax when you’re done with investments at the long term capital gains rate.  

When would you use it?

As an investor,  you’re always hoping that your property is worth a lot more now than when it was originally purchased.  If that’s the case, you’re on the hook for taxes on those gains when the property is sold. That’s where a 1031 exchange comes in.  You can use those gains to purchase another like-kind investment to put off recognizing those gains with the IRS.

You might be wondering what like-kind means. Think of it as one piece of real estate for another.  Do you fancy buying a big, new airplane with the proceeds from your investment in an apartment building?  Think again. The tax code only allows real estate to be used. Thinking about exchanging a primary residence?  That’s not included either. The 1031 exchange rules apply only to investment and business property.

Delayed Exchange

The original “swap” of two properties under 1031 was just that, an exchange between two people for two properties, but these days it’s much more likely that you’re not swapping ideal pieces of investment properties between neighbors. There is usually a gap between the time you sell your property and obtain a new one.  This is referred to as a delayed exchange. For this type of exchange, you’ll need to find a Qualified Intermediary, aka a money man, to hold your proceeds and purchase the new property for you.

There are also reverse exchanges for those investors who first purchase a new property and then identify other properties they own to relinquish in the exchange.

Identifying Replacement Properties

In a delayed exchange,  there are two key deadlines that need to be met.  After the sale of the initial property, you have 45 days to notify your intermediary of the property you want to purchase with the proceeds.  The good news is, you aren’t limited to just one. You can identify up to three properties with no limits on their fair market value, but you must close on at least one.  Another option is to identify 4 or more properties as long as their combined fair market value does not exceed 200% of the value of the relinquished (sold) property. The last, and most dangerous option, you can identify an unlimited amount of properties, but you have to close on 95% of them.

The next critical deadline is the closing on the new property. It must occur within 180 days of the sale of the previous property, known as the exchange period.

Avoid the “Boot”

No, they won’t kick you out,  but you could stand to get money back if your exchange isn’t exactly equal.  That amount you get back is called “boot”, and it’s taxable. This could happen if you sold a property for $100,000, but only purchased a $90,000 replacement investment.  You would be taxed at capital gains rates on $10,000. The more likely scenario getting investors in trouble with boot is forgetting to account for mortgages. Even if you don’t receive cash back,  a decrease in liability, like a lesser mortgage on the new property, is still a taxable gain.

Note the costs associated with acquiring the property,  such as inspections and some closing costs do count towards your total cost of the new property.

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Getting Started

If you haven’t started snoring yet, it’s a good sign that a 1031 exchange might be just what you need to grow your investment portfolio.  This article is an overall explanation of 1031 exchange rules, but the process and the rules can get complex. It’s critical to have great resources that can help guide you through the process if needed.  Start by finding a qualified intermediary in your area to review 1031 exchange rules and confirm your property qualifies.

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