In this article, we will discuss how to do a 1031 exchange with real estate. Topics include: what is a 1031 exchange, 1031 exchange rules, types of exchanges, success stories, and more.
1031 is a powerful tool that will help an individual to save taxes after the sale of a property. It is a tax deferral program that allows the investors to sell a real estate property and then invest the funds that they have earned in another real estate property. The investor won’t be receiving cash at all, and this helps them in saving a good amount of money in the form of taxes. The entire transactions are authorized by 1031 of the IRS code. Most of the people do not have a clear idea about this 1031 exchange. This article will help you in understanding the fundamentals of 1031 exchange and how can you invest in it.
What is the 1031 Exchange?
Let’s consider a simple example- a person brought property for $200,000, and when he thought of selling it, the price of the property was $400,000. If he traditionally sells the property, he will be liable to pay a good amount in the form of taxes, but if he exchanges the $400,000 worth property with another likewise one, he won’t be liable to pay tax on the exchange.
The Internal Revenue Code gives this exchange opportunity in the name of 1031 Exchange which is also termed as Starker loophole.
The similarities between the two properties don’t depend upon the quality. The revenue is the basis to understand whether to properties can be exchanged or not. The 1031 Exchange is strictly limited to business properties only; one cannot use this for domestic or personal properties.
Why Should One Consider the 1031 Exchange?
A property that is sold for gain is subjected to taxation. These taxes can be summed up quickly, and the owner of the property is liable to pay up to 37.5% of the amount in the form of taxes. But the 1031 exchange gives an option for the property owners to exchange their property with another one and avoid some of the taxes. It is a better way to save up some money. It allows better cash flow; easier management and one can exchange their property with the one that is present in their desired location. There are so many benefits of this 1031 exchange that made people interested in it.
1031 Exchange Rules Explained
There are 7 primary 1031 Exchange the rules. These include:
- Like-kind property
- Investment or business purposes only,
- Greater or equal value
- Must not receive “boot,”
- Same taxpayer
- 45-day identification window
- 180-day purchase window.
Rule 1: Like-Kind Property
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.”
Like-Kind Property Definition: Like-Kind property is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” (4) In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
- Exchanging an apartment building for a duplex would be allowed.
- Exchanging a single-family rental property for a commercial office building would be allowed
- Exchanging a rental property or vacation rental for a restaurant space would be allowed.
EXCEPTION: It’s important to note that the original and replacement property must be within the U.S. to qualify under section 1031.
**Another fun fact: Starker Exchanges can include more than two properties. For example, you can exchange one property for multiple replacement properties and vice versa: you can exchange multiple properties and for one larger property. As long as the new properties are like your original properties, you’re good to go. Do yourself a favor and get a good qualified intermediary to assist you.
Rule 2: Investment or Business Property Only
A 1031 exchange is only applicable for Investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
- If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.
- If you were to get married and move into the home of your partner, you could not exchange your current primary residence for a vacation property.
- If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.
Rule 3: Greater or Equal Value
To completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of 1031, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)
Rule 4: Must Not Receive “Boot”
A Taxpayer Must Not Receive “Boot” for the exchange to be completely tax-free. Any boot received is taxable to the extent of the gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax-free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay and often used when a seller wants to make some cash and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”
Rule 5: Same Tax Payer
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and titleholder that buys the new property. However, an exception to this rule occurs in the case of a single-member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.
For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, she can purchase property in her name, and be in compliance with the 1031 code.
Rule 6: 45 Day Identification Window
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
Rule 7: 180 Day Purchase Window
It’s necessary that the replacement property is received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
1031 Exchange Process Involved
The entire 1031 exchange can be divided into two parts- before selling Relinquished Property, after selling Relinquished Property. The property that the taxpayer sells first is termed as Relinquished Property and the one he/she exchanges with is termed as Replacement Property.
- The 1031 Exchange usually starts with the regular sale agreement and purchase. The first thing that seller has to do is to get into a common sale agreement.
- Then they have to get into an agreement with the QI (qualified intermediary) for both exchange and escrow. The entire amount that they got from selling the property will go to the escrow now. The QI takes ownership of the property for some time, and the buyer is given the title of the property.
- From here the QI takes the entire procedure into its hands.
- 45 Day Identification Window- The property owner has complete 45 calendar days after selling the first property to identify the like-kind properties. This is the hard part because the taxpayer will need some time to determine the properties and know their worth. The taxpayer should pick four like kind of properties. In these 45 days, the properties that are chosen by the person are only considered for exchange. They cannot select new properties after 45 days.
- There is an exception here, and it is 200 rules. The taxpayer has a chance of selecting 4 or more properties that will be less than or equal to 200% of the price of selling property in exchange.
- 180 Day Purchase Window- The taxpayer should buy any one of the four properties by the end of the 180 days before closing the first deal which means he/she will be having 135 days left to purchase the 45-day identification window.
- Now as you already identified the property and chose to exchange it with yours, the QI will start the further procedure. The assignment of the contract, mandatory notification of the assignment, and information document will be prepared. The QI will take care of transferring the money from escrow to the seller and if any amount is left over it will be sent back to the taxpayer, and it will be taxed.
1031 Exchange: Some Pointers to Remember While Opting
The entire 1031 Exchange has its pros and cons, so you need to go with a reliable and qualified intermediary. The intermediary plays a critical role in the entire process, and you should be smart while choosing one.
If the property that you have sold is under your name, then the property that you will buy in 1031 Exchange will also contain your name only. There is an exception for the single-member limited liable company (SMLLC). The property that is under the name of SMLLC can be sold, and the single owner can buy it under his name.
The LLC’s cannot do the same, and the title of both properties must be the same.
1031 Exchange Conclusion
The entire 131 Exchange is complicated and has so many rules that must be abided. A single mistake can throw the entire deal under the bus, and it is vital to get professional help to take care of this process. If you understand clearly about the 1031 Exchange and the rules, regulations that are present in the process it will become more comfortable for you to proceed with. With the technology and professional help at a place, the utterly complicated 1031 Exchange will surely seem easier and simpler. All you have to do is read and understand the basics once, and you will be good to go.