A 1031 Exchange is a strategy to defer taxation used by most of the most successful investors in real estate. It is a strategy that allows the sale of a property and the purchase of another property where the capital gains tax is deferred.
You heard that right. You can defer (put off being taxed) to a later date!
That means you can make money, not be taxed, use 100% of your money to buy a better investment. Then, you can do the same thing over and over again, putting the taxes off for a future date.
Some rules and regulations must be met to complete a procedure of these characteristics. Here you will find the information you need to understand the 1031 Exchange:
If you own properties as investments, you have probably already heard of the 1031 Exchange, or the Starker Exchange. You might wonder, what is a 1031 Exchange in real estate, and why is it convenient?
What Is a 1031 Exchange in Real Estate?
The definition for the 1031 Exchange can be found in the U.S. Internal Revenue Code under Section 1031.
To summarize, Section 1031 allows the owner of an investment property to sell said property and “defer” the payment of capital gain taxes as long as the proceeds are reinvested in a property (or properties) of similar value and like-kind.
The spirit of the law is to be applied for cases where you exchange one property for another of like-kind. But the probability of doing such a literal exchange is very low.
This is why most of the exchanges are delayed, three-party exchanges. We will learn more about that in the next section.
How Does a 1031 Tax-Deferred Exchange Work?
There is more than one kind of exchange an investor can choose from. In this section, we’ll describe the four main types of 1031 Exchange and when you should use each one.
1. Simultaneous 1031 Exchange
This happens when the exchange of two properties happens simultaneously. The relinquished property and the replacement property have to close the same day.
It should be noted that any delay can cause the exchange to be disqualified. In that case, full taxes are applied.
A simultaneous exchange can happen in one of these three basic ways:
- Two-party exchange: the two parties exchange the deeds of their properties.
- Three-party transaction: a third party is used to make sure that the exchange happens simultaneously.
- Middle-man exchange: a qualified middle-man takes care of organizing the transaction.
2. Reverse 1031 Exchange
The reverse exchange, or forward exchange, happens when you buy a property and exchange it later.
This kind of exchange can be more difficult to carry out because it needs to be paid fully in cash, and many banks won’t give out loans for this type of transaction.
Additionally, the investor must decide which property they are going to buy and which one they will relinquish.
There are some time constraints:
- The investor has 45 days to identify the property that is going to be relinquished.
- The investor has 180 days to complete the sale of the relinquished property and close the exchange by purchasing the replacement property.
3. Delayed 1031 Exchange
This is the most popular kind of exchange today. It happens when the exchanger gives up their property before acquiring a replacement, i.e., the relinquished property is transferred before the replacement property is acquired.
Before the delayed exchange process can begin, the exchanger needs to market the property, secure a buyer, and execute a purchase agreement.
Once this is done, they must hire a third party to initiate the sale of that property and hold the total amount of the sale for no more than 180 days while the exchanger buys a like-kind property.
This timeframe is the main reason why this kind of exchange has become so popular.
4. Construction 1031 Exchange
This allows the exchanger to use the exchange equity to improve the replacement property while said property is held by an intermediary for 180 days.
However, for the investor to defer all gain, they must spend the entire sum on improvements before the end of the 180 days, and the improvements must be completed before the property is deeded back to the investor.
The 1031 Exchange Rules to Defer Taxes (put off for a future date)
Some rules need to be followed when attempting a 1031 Exchange. Here we explain the seven rules:
1. Like-Kind Property
To be able to carry out a 1031 Exchange, the properties being exchanged must be like-kind.
This is a broad definition, but it means that the properties must have the same nature.
In practical terms, you can do this with almost any kind of property if it is not personal property.
For example, you could exchange a rental property for a duplex.
2. Investment Property Only
In a similar vein, the 1031 Exchange cannot happen when either one of the properties in question is personal property. This means that you can’t exchange your home in Florida for a home in California.
However, if you owned a rental property in Florida, you could exchange it for a rental property or a commercial rental property in California.
3. Same Taxpayer
The name on the tax return and the title of the property being sold must be the same name as the tax return and titleholder that acquires the new investment property.
There is an exception to this when it comes to a Single Member Limited Liability Company.
In that case, the SMLLC may be the one selling the property while that single member can acquire the new property under their own name.
4. Value Must Be Greater or Equal
To defer the total amount of the tax on the sale of the property, the property purchased must be equal or greater than the property that has been sold. Otherwise, you would have to pay some percentage of the tax for the sale of your property.
5. Property Identification Timeline
The property owner has 45 calendar days after the closing of the first property to identify potential replacement properties.
6. Exchange Timeline
The exchange must be completed (i.e., the replacement property must be received) before 180 days have passed after the sale of the relinquished property.
7. Partial Exchange
If you carry out a partial exchange, meaning that the property you buy is of lesser value than the property you relinquish, then the transaction will not be completely tax-free.
The difference in prices is the amount that will incur capital gain taxes.
What Is the Timeline for 1031 Exchange?
The timeline for a 1031 Exchange will depend on which type of exchange you choose to participate in.
However, the basic timeline that must be followed is that described in rules 5 and 6 above.
For a delayed exchange, for example, two timeline rules must be observed:
- Once you have sold your property, the third-party intermediary will receive that money.
If you are the one to receive the money, you are no longer eligible for a 1031 Exchange.
You must decide on a replacement property within 45 days of the sale of the relinquished property and notify the intermediary in writing.
- You have 180 days after the sale of your property to close on the new property.
This 180-day period begins as soon as the sale of your original property is finalized, not after you identify the replacement property.
That means that if you identify the replacement property 45 days after the sale of your property, you only have 135 days to close on it, not 180 days. The two periods are calculated concurrently.
Practical Example of a 1031 Exchange in Real Estate
All of this can be confusing, so we’ll give you some examples to illustrate how this exchange could take place.
Mary owns a property that she paid $300,000 for and will now sell for $450,000. She has a $150,000 mortgage against the property. Mary intends to buy an apartment for $300,000 with the leftover cash.
Does this mean that Mary qualifies for a complete tax deferral according to the 1031 Exchange?
No, in this case, Mary is buying down from $450,000 to $300,000. Since she is not complying with the equal or greater value rule, she has to pay taxes for the difference of the buy down: $150,000.
If Mary wanted to invest in a property priced at $450,000 or $500,000, then she would be eligible for a 1031 Exchange and would be able to defer 100% of the taxes.
Conclusion of What Is A 1031 Exchange in Real Estate
As you can see, making use of this strategy requires careful consideration and an education in order to make the most of it.
However, it is not impossible to do as long as one carefully studies its regulations.
The 1031 Exchange in real estate is NOT a complicated transaction, even for beginners. The best thing to do is to ask professional accountants and even title companies and seek their counsel.
Hopefully if you are wondering what is a 1031 exchange in real estate, you know now that every investor can defer (put off) their taxes to a much later date.
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