For the savvy investor, there are all kinds of ways to build your wealth, whether you're in your 30s, 40s, or even your golden years with grandkids and Social Security.
But part of building your wealth involves expanding your investment portfolio, especially in real estate investing. And you have to know how to invest.
Part of knowing real estate investment is understanding 1031 exchange real estate. That's where we come in. Keep reading to find out everything you need to know to maximize your investments.
What Is a 1031 Exchange?
First, you need to understand what a 1031 exchange is.
The full code states: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment.”
So, what does that mean in plain English?
Basically, a 1031 exchange is when you swap one investment property for another. Most exchanges like this are taxable as sales, but if the exchange meets the requirements of 1031, you'll have limited or no tax due at the time of exchange.
Sounds like a pretty good deal, right?
How It Works
A 1031 exchange works on a specific premise.
In order for an exchange to qualify, you must change the form of your investment without recognizing a capital gain or cashing out (in the eyes of the IRS, anyway). Because of this, your investment will continue to grow in a tax-deferred state, uninterrupted.
To understand how it works, let's look at an example.
Let's assume the following:
- An investor has $400,000 in gain
- They also have $400,000 in net proceeds after closing
- They incur roughly $140,000 in combined tax liability when the property is sold
- This leaves them only $260,000 to reinvest elsewhere
If they have a 25% down payment and have to take on new financing at a 75% loan-to-value ratio, they can purchase a new investment property worth $1,040,000.
But, if the investor chose to do a 1031 exchange instead, they could reinvest the entire $400,000 gross equity to purchase a new investment property worth $1,600,000 (assuming the same down payment and LTV ratio).
In order to do this, the investor must exchange one property for another property of similar value. However, the purchase price and new loan amount of the replacement property must be the same or higher than the original property.
This way, you'll have a profit on each exchange, and you'll only have to pay one tax at a long-term capital gain rate when you sell the property for cash at a later date.
Basics of a 1031 Exchange
There are four types of 1031 exchange:
- Simultaneous exchange
- Delayed exchange
- Reverse exchange
- Construction/improvement exchange
A simultaneous exchange is when the original property and the replacement property close on the same day. These must be simultaneous–any delay can result in disqualification of the exchange and immediate application of full taxes.
A delayed exchange is the most common type of exchange, in which the exchanger (you) relinquishes the original property before acquiring the replacement property.
A reverse exchange is when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement. Basically, you buy first and pay later. These exchanges are tricky because they require all cash, and many banks don't offer loans for this type of exchange.
Finally, a construction/improvement exchange is when you (the taxpayer) can use your tax-deferred dollars to make improvements on the replacement property while it remains in the hands of a qualified intermediary for the remainder of the 180-day period.
Things to Know About 1031 Exchanges
With all of that in mind, there are quite a few rules attached to 1031 exchanges. These rules must be followed to a tee, or you'll never see the benefits of 1031 exchanges.
Let's take a closer look at some of the rules that impact these exchanges.
1031 Exchange Real Estate Must Be Investment Property
The most basic rule to live by is actually quite simple: 1031 exchange real estate must be an investment property, not personal property.
That's because the provision of the tax code was designed solely for investment and business property. If you're a regular homeowner living in the home you're buying or selling, you can't do a 1031 exchange.
You also cannot exchange an investment property for personal property, or exchange personal property for investment property. Both properties on either side of the equation have to be investment properties, whether you plan to rent the property to tenants or flip it after a renovation.
There is one small caveat. There are ways that you can exchange vacation homes under a 1031 exchange, but this loophole is small (and quite a bit narrower than it used to be).
Personal Property No Longer Qualifies
Before the new tax law passed in December 2017, some exchanges of personal property qualified for a 1031 exchange. This included things like:
- Certain equipment
- Franchise licenses
Under the new tax law, that provision is no more. If you want to do a 1031 exchange, you can only use real estate–and that real estate has to be an investment property.
However, there are a few disclaimers.
Exchanges of corporate stock and partnership never qualified, under the old tax law or the new one. But interests as a tenant in common in real estate still qualify.
Now, if you're in a limbo period, there is a transition rule that can help you. The new tax code contains a provision which states that a 1031 exchange of qualified personal property in 2018 is permitted if:
- The original property was sold before December 31, 2017, or
- The replacement property was acquired before December 31, 2017
The provision does not permit a reverse 1031 exchange (the new property is purchased before the old one is sold).
“Like-Kind” Is Broad
Under a 1031 exchange, the rules state that you must do a “like-kind” exchange, in which one investment property is exchanged for another investment property of comparable value.
However, like-kind doesn't mean what you think it means. It's actually much broader than most people realize.
For example, let's say you have an apartment building. You don't necessarily have to exchange it for another apartment building in order to have a like-kind exchange. You could exchange it for a strip mall, or a ranch, or even raw land.
So long as the new property is of comparable value, the exchange is allowed.
Now, you may want to calculate your cash flow on one property versus another, but the broadness of “like-kind” opens up your options considerably.
You Can Do Delayed Exchanges
Reading all of these rules and guidelines around exchanges, you might think that you have to have a replacement property lined up and ready to go before you even consider an exchange.
In fact, you can do a delayed exchange, which is actually the most common form of 1031 exchange.
In a delayed exchange, the relinquished property is transferred out of the investor's hands before the replacement property has been acquired.
If that sounds an awful lot like simply selling the original property and finding a new one, that's because you don't know the rules attached to a delayed exchange.
In a delayed exchange, the investor (you) is responsible for marketing the original property, securing a buyer, and executing a purchase agreement before they can initiate the delayed exchange.
From there, the investor has to hire a third-party intermediary to initiate the sale of the relinquished property and hold the proceeds in a binding trust while you acquire a like-kind property. This trust can be held for up to 180 days.
Under this strategy, you have up to 45 days to identify a new property and up to 180 days to complete the sale of the original property. You need the intermediary to hold the proceeds for you in order to show the IRS that you didn't cash out or make capital gains.
Make sure you know the process of finding a replacement property–now is not the time to mix and match your investment methods, like purchasing real estate with a 401(k).
Replacement Property Must be Designated
Regardless of the type of exchange you choose, all exchanges have one factor in common: a replacement property must be designated.
Let's go back to our delayed exchange example.
When you sell the original property, the intermediary receives the cash from the sale. If they don't, the 1031 exchange is spoiled and you have to pay taxes on the exchange.
This might seem confusing–after all, how are you supposed to find a replacement property without the proceeds?
Keep in mind, though, that you're not buying replacement property. You're designating replacement property. This is why you don't need the cash in your hands.
You have 45 days to find a replacement property and designate the property you wish to acquire in writing to the intermediary. They'll handle the acquisition for you, thus facilitating a successful exchange.
You Can Designate Multiple Replacement Properties
Now, if you're a savvy investor who knows the ins and outs of the real estate market, that 45-day limit may make you nervous. How can you expect to find an exact replacement in that time?
You don't need to find one perfect replacement. In fact, the IRS allows you designate up to three properties as potential replacements–so long as you eventually close on one of them.
There are certain cases where you can designate more than three potential replacements if the properties fall within certain valuation tests, but most of the time, you'll designate three.
You Have to Close in Six Months
Keep in mind, however, that under the rules of delayed exchanges, you have to close on the new property within six months.
Specifically, you have to close on the new property within 180 days of the sale of the old property–you start counting when the property closes. The two time periods run concurrently, so if you use the full 45 days before designating a replacement, you'll only have 135 days left to close.
(put in a paragraph talking about how a turnkey property provider will have inventory that you can identify within 45 days typically. JWB always has between 10-25 properties that area available at all times for our client to purchase (link to www.jwbrealestatecapital.com as they can download our 2 property evaluations there.)
If You Receive Cash, It's Taxed
All exchanges follow the same basic rule: if you receive cash, it's taxed, even if you did complete a successful 1031 exchange.
That might not make sense until you consider the full circumstances. You may have cash left over from the original sale after your intermediary acquires a replacement property, which the intermediary will pay to you at the end of the 180-day period.
This cash is known as boot and will be taxed as partial sales proceeds from the sale of your relinquished property.
Consider Mortgages and Other Debts
One of the main ways that investors get in trouble in these types of exchanges isn't the waiting period, or in trying to find a replacement property, or the capital gains leftover from the sale of the original property.
Most investors actually get in trouble because they fail to consider mortgage loans.
You have to think about the loans and debts on the property you relinquish because any gains left from the sale will be taxed.
Put it this way. Let's say you had a $900,000 mortgage on the old property, but the mortgage on the new property is only $700,000. That leaves you with $200,000 in gains, which is classified as boot and will be taxed since the IRS views it as income.
More Real Estate Guidance
There's quite a lot you can do with 1031 exchange real estate and quite a lot of ways a clever investor can turn a tax-deferred profit.
The key is knowing how to invest. That's where we come in.