Among the various tax deferment provisions tucked into the federal tax code is a potent wealth-building tool for real estate investors: the 1031 exchange. If certain requirements are met, it allows real estate investors to defer taxes on the sale of a property by investing the proceeds into another investment property. The requirements take careful study, which we will cover in this overview.
What is a 1031 Exchange?
The 1031 exchange is so named from the section of the U.S. tax law from which it is used. Also known as a like-kind exchange, it allows a real estate investor to sell an investment property and defer, not avoid, capital gains taxes on the sale. This can only be done if the like-kind property is identified and purchased with the proceeds within a certain time. Both properties must be owned for business or investment use.
Gains can be rolled from property to property over a period of years. The gains only become taxable once they are realized by a cash-out sale, without being reinvested.
Used effectively, the 1031 exchange is an excellent means of growing wealth over the years by deferring taxes so that the maximum amount of available capital continues to work and grow.
What is a like-kind property? The tax code gives the investor some leeway as to the type of property for which the sold property is swapped. Swaps can be done with residential rental properties, shopping centers, warehouses, working farms or ranches and more. Using a commercial real estate professional like a CCIM can help you meet the like-kind requirement.
Vacation homes used as rentals can be swapped under certain, limited conditions. Under certain requirements, the 1031 provision can also be used for a home that was formerly a private residence.
Meeting required deadlines
Ideally, you already have an available like-kind property in mind when you sell. This doesn’t always work out, so a simple clean swap may not be available. In that case a delayed swap can be done under certain conditions.
In a delayed exchange, a qualified intermediary acts as a middleman. This middleman works with your real estate professional to help you secure the replacement property. This is a licensed professional who takes your cash in a type of escrow account and will use it to purchase the next property for you. You cannot take possession of the cash proceeds of the sale, since this could negate 1031 eligibility.
45 days is the amount of time you have from the sale of the first property to identify the next property and notify your intermediary in writing of your intent to purchase.
You must close on the new property within 180 days of the close of the first property. This clock runs concurrently with the 45-day rule. For example, if you notify the intermediary of the new property right at the deadline of that 45-day rule, you have 135 days remaining to close on the new property.
Another way to make a 1031 exchange is called a reverse exchange. In this case the investor purchases the new property before selling the currently owned property. Often the investor knows which property he or she intends to sell. Title to the new property is held by a person known as an exchange accommodation Titleholder. Now the deadlines apply to the property to be sold: 45 days to identify the property to sell, 135 days thereafter to close.
Additional tax rules
There are a few other tax implications to understand.
If you retain part of the cash from a 1031 exchange it is taxable, usually as a capital gain.
If you have a mortgage on the property sold and exchange for a property with a lower liability mortgage, the difference is treated as taxable income.
Finally, if you exchange depreciable property for non-depreciable property, such as land with buildings for undeveloped land, you will be subject to the recapture of the depreciation from the developed property, incurring an ordinary income tax liability on the recaptured depreciation.
A vacation home can be swapped with another house if you stop using it yourself and rent it out for six months to a year before the exchange.
The 1031 exchange is a powerful tool for helping a real estate investor build wealth through tax deferral. It is important to have a professional agent like a CCIM guide you through the process. A CCIM can ensure that you meet the tax code requirements for an acceptable transaction.
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