At some point in your real estate education you will undoubtedly hear of a "1031 exchange." Personal finance gurus and savvy real estate investors constantly trumpet the value of this tool as a vehicle to avoid capital gains tax. While you might not fully comprehend what it is, you definitely know you don't want to pay tax if you don't have to!
We all dream of (legally) turning the tables on the IRS -- a 1031 exchange is one of the few times they actually make it possible. The only problem? Well, some of the nuances of this "legal loophole" can be pretty tricky to master. But at TrueParity, we believe that smart real estate investors should never need to know every single detail themselves. They just need to know where to get help.
Below we'll cover the basics -- and not so basics -- of the 1031 exchange. Then we'll highlight why you absolutely want a best-in-class real estate agent to help you get it done, and fastrack you toward your financial goals.
The Basics of a 1031 Exchange
Here's the 30,000 foot view. A 1031 exchange refers to the tax code (literally the section of the Internal Revenue Code used by the IRS) for the situation where an investment property is swapped for another without triggering an immediate capital gains tax payment.
Normally, if you sold an investment property (or any other type of investment) you would have to pay capital gains taxes on that income. Capital gains tax can vary, but the one universal truth is that every real estate investor is desperate to avoid paying it. It can severely hamper your monetary return and skew your overall investment strategy.
The way it works is when you sell one investment property, you have 45 days (from the date of the sale) to identify potential replacement properties. This identification process is done formally in writing; but it does not guarantee the purchase of a replacement property. In fact, you can identify up to three replacement properties or any number of properties so long as the combined fair market value does not exceed 200% of the original property.
To fully complete the 1031 exchange, you must purchase the replacement property (or properties) within 180 days of the sale of the relinquished property. The proceeds of the sale must never reach your pocket; if you touch that money at all you'll be required to immediately pay taxes. An independent party called a QI (Qualified Intermediary) holds the exchange funds until the new property purchase is complete.
If the 1031 exchange is handled correctly, a real estate investor can defer capital gains tax and also defer tax liability for any gains from depreciation recapture (which could alter your tax basis to create a more unfavorable scenario). This is simply an unbelievable tool to reallocate the assets in your portfolio while preserving equity.
But Wait -- There's More!
While a 1031 exchange sounds simple, it can quickly get confusing. There are a number of significant wrinkles and gotchas to the exchange process that can trip up even the wisest investor. A few things to note:
New Property Requirements
- Equal or greater value: The new property (whether it is one property or multiple properties) must be (at least) the same value as the relinquished property. Otherwise, you would record a gain in the swap that will carry tax implications.
- "Like-kind" property: Also, the properties must be the same "kind." This means they both must be real property (not an intangible asset) and function as business or investment properties. Note that like-kind does not imply like-class or like-quality. If you sell an office building you can use a 1031 exchange to buy a single family home or an apartment building or even vacant land, provided you use them to generate income, conduct commerce, or keep in your investment portfolio as a long-term holding.
- Business or investment property: Just in case it wasn't clear! A 1031 exchange does not pertain to your primary residence. Both the relinquished property and the replacement(s) must be investment properties.
Timing
- Simultaneous exchange: Of course, the absolute easiest way to execute a 1031 exchange is at the exact same time. You sell one investment property while you buy the next. However, life -- and market -- circumstances rarely align with such serendipity.
- Identifying replacement property: As mentioned, you have 45 days from the sale of your original property to submit your shortlist of new property of equal or greater value. Then you have 180 days to actually complete the acquisition. This is called a delayed exchange and is by far the most frequent type of 1031 exchange.
- Reverse Exchange: There's also an option of doing a reverse 1031 exchange. In this scenario, the replacement property is bought before the original one has been relinquished. The same 180 window applies, as does the requirements re: ownership. In a reverse exchange the title of the replacement property must be held by an intermediary (called an "exchange accommodation titleholder" or EAT) until the relinquished property sale is complete.
More to Think About
- Location: Perhaps a no-brainer, but a 1031 exchange only applies to properties in the United States -- if you try to move your investment out of the country then the IRS will hit you with capital gains tax and NIIT (net investment income tax). Less obvious is what happens when your replacement property is in another state. While it certainly falls within fair ground of the federal government, you need to exercise caution that your remain compliant with each state's requirements.
- Property conversion: While the law is clear that a 1031 exchange only pertains to investment or business property, your goals for your real estate holdings may change over time. What happens if you execute a swap and one day you decide you want to move into your rental property? While it is not directly prohibited, there are particular considerations that require expert guidance.
- Property improvements: You can use the net sale proceeds of the relinquished property to make real improvements to your replacement property. But there are timing considerations that come with them.
- Ownership change: Perhaps the dissolution of a business partnership precipitates the sale of one property, and both the separating parties want to do a 1031 exchange (seeking to defer capital gains taxes individually). How can this be done without switching the titleholder and taxpayer of record? Well, this is yet another particular scenario that forces you to make sure you've thoroughly covered all your bases.
- Estate planning: It's not all bad news though. When properly utilized, the 1031 exchange can help facilitate and stimulate generational wealth. When a property owner dies, with capital gains still deferred from a lifetime of doing 1031 exchanges, the heirs inherit the asset at a stepped up basis equal to the value of the property at the time of death. Meaning, they don't pay capital gains taxes, NIIT, or depreciation recapture. Getting this right could position your family for financial stability for decades to come.
Why You Need a Top Agent
If you're starting to think this actually sounds like it can get pretty complicated -- you are correct. Of course, it's admirable to try to educate yourself on the workings of the 1031 exchange (hey, you are reading this blog post after all!). However, in the trenches of investment real estate, discretion is indeed the better part of valor.
You need an experienced and knowledgeable expert to guide you through the many nuances that accompany tax deferred exchanges. You not only want to make sure that process goes smoothly and remains in total compliance with all tax code, but also need someone to take into account all the particular details of your situation. In short, you need someone who can help you come up with the best gameplan for you and your financial goals.
A qualified real estate broker should be your first resource. Who else would know the best practices around the real estate market better than the agent you've selected to sell your property? Sure, you could hire a great real estate attorney or qualified intermediary, but why pay another party when you've already got a fiduciary working on your sale?
If your listing agent isn't your immediate answer to these questions, then you need to aim a little higher when picking an agent. Don't settle for a friend or family member with a real estate license; you need an elite expert in your area who can deftly oversee every part of the process -- both your property sale and the associated 1031 exchange. Your tax return will thank you.
Want to connect with the top real estate agents in your neighborhood?
Post your property on TrueParity's innovative platform and meet an expert on 1031 exchanges today.
