Blocks & Lots

1031 Exchange: everything you need to know

Most people know that they will be liable for a capital gains tax if they sell an investment property and plan to keep the profits. However, if the seller reinvests the profit in another investment — but takes their own time in doing so — they will still be in for a nasty shock from the IRS. However, a 1031 Exchange structures the reinvestment process to eliminate or decrease capital games taxes.

This tax deferral program permits the investor to sell a real estate property and then reinvest the funds in a property of equal or greater value. There are strict guidelines, however, in undertaking a 1031 Exchange. Here are the six main rules investor must adhere to.

The 6 underlying rules of a 1031 Exchange

  1. In a 1031 exchange, the properties involved must be held for either business or investment purchases. You cannot conduct a 1031 exchange on your primary residence.
  2. The IRS requires that the investor identify their purchasing plans on day 45. The investor must describe the property or properties they are planning to use as the replacement in the exchange.
  3. The IRS also has a strict timeline that the investor must uphold. The investor has 180 days to complete the exchange. This begins on the day escrow closes on the sale.
  4. The investor must also work with a qualified intermediary. This is a third party that holds the money for the exchange in escrow.
  5. The title on the new purchase must be identical to the old property. For example, if the first property was held in an individual’s name, that person cannot put the new purchase in their LLC.
  6. A 1031 exchange permits the investor to sell a real estate property and then reinvest the funds in a property of equal or greater value. The investor cannot make a purchase for less than the original property. This would defeat the purpose of deferring taxes on a gain.

Other important facts about a 1031 Exchange

Partial 1031 Exchange

If an investor does buy a property in a 1031 Exchange for a lesser value that property they are selling, they would be liable to pay taxes on the difference. This is known as a partial 1031 Exchange.

Debt must be equal

The debt amount on the sales property must be equal to that on the new purchase. For example, if the mortgage balance on the property being sold was $100,000, that same amount must be the debt carried on the new purchase

A 1031 Exchange can apply to more than one property and it does not need to be like for like

If the property being sold is a $1M investment condo, the seller does not need to buy another investment condo or even another residential property. As long as the new purchase will be used for commercial use — ie four single-family rentals, a storage facility, hair salon or a book store — a 1031 Exchange can be applied. 

The rules about identifying a replacement property

You are required to submit your purchasing plans to the IRS by day 45 of closing and your sale proceeds being placed into escrow. There are two rules you can follow:

The 3-property rule: If you choose to follow the three property rule, you can identify three properties of any value. You must then purchase your replacement property from that list by the end of the exchange. 

The 200% rule: This rule does not set a limit on the number of properties that you can identify, but the total value cannot exceed 200% of the property that you sold.

You’ll get by with a little help from your friends… or 1031 Exchange professionals

A 1031 Exchange is not a process to be undertaken alone. In fact, you are not allowed to do it alone. You are required to enlist the help of a qualified intermediary. They are also referred to as an accommodator or facilitator because they facilitate the entire transaction. Their role is that of a neutral third party that holds the money for the exchange in escrow. As an investor, you are not to allowed to touch the funds from the sale of your property during a 1031 exchange. Any money you do personally receive from the sale of your property makes you liable for capital gains taxes.

What are the main advantages of a 1031 Exchange?

Firstly it is a legal way to avoid paying capital gains taxes — around 33% — which is a huge wealth-building tool. Secondly, it allows an investor to diversify their portfolio and boost profit. One piece of property can be exchanged for other, potentially more profitable properties.

Long term deferral to aid estate planning

The beauty of a 1031 Exchange is that there are no time limits in how many properties you wish to Exchange. Property after property can be bought and sold with 1031 Exchanges and the taxes will continuously be deferred. The tax bill expires upon the owner’s death, a rule which has helped coin the phrase, “swap until you drop.” This means that properties can be passed on to family members without any capital gains tax liability.

Pay attention to the title

Close attention must be paid to the title in a 1031 Exchange. The title on the new purchase must be identical to the old property; the IRS wants to see the exact taxpayer on each title. For example, if you owned the first property in your own personal name, the replacement property must also be purchased that way. You cannot put the replacement property in an LLC, trust, retirement account, or someone else’s name; the titles must be identical to ensure a successful transaction. 

If you need to change the title later (for example, transfer the property from your personal name into your LLC), you can always complete a quitclaim deed after the 1031 exchange has occurred.

How to get started with a 1031 Exchange

Timing is everything with a 1031 Exchange. You cannot afford the luxury of taking it easy. The first step is to have your closing lawyer put you in touch with a qualified intermediary long before you sell your property. The intermediary will need to set up an escrow account for the funds received. Also, make sure you have a real estate savvy CPA on your team. You’re going to need them. Good luck!