What is a 1031 Exchange and how does it apply to you?

What is a 1031 Exchange and how does it apply to you?

Let’s get right to it. Most of you reading this article have heard of a 1031 exchange at some point in a real estate conversation. In my experience, most people do not know much about this opportunity. A 1031 exchange is commonly referred to as a “like-kind exchange” and refers to Section 1031 of the US tax code. Simply stated, it is the act of swapping one investment property for another. The benefit of this swapping process is the elimination or reduction of taxes due on capital gains at the time of the exchange. As an investor or a real estate professional working with commercial clients, a like-kind exchange can have a profound effect on the bottom line when selling property, and is an essential tool for building a successful portfolio.

By swapping one property for another, an investor is avoiding a sale and in turn avoiding a capital gain in the eyes of the IRS. Rather than paying the capital gains tax on the sale, which at the time of this article is between 15% and 20%, an investor can use the full amount of the sales proceeds and roll into a similar sized or larger investment property. This allows the investment to continue to grow tax deferred with no capital gains chunks taken out. This process can be repeated an unlimited number of times, and if done correctly, will drastically speed up the accumulation of wealth for an investor.

There are many nuances and advanced strategies associated with like-kind exchanges, but below is a list of the basic guidelines that an investor will need to follow:

1) This is not for personal use. It is only for business use. You cannot do an exchange with your personal home.

2) Certain rules apply when depreciable property is exchanged. This type of exchange can trigger a gain known as depreciation recapture, which is taxed as ordinary income. Typically if you exchange improved property (a property with a building) for other improved property, this tax will not apply. However, if you exchange improved property for unimproved property or raw land, the depreciation you claimed on the improved property will be recaptured as ordinary income.

3) Only real estate or businesses qualify for a 1031 exchange.

4) In order for the exchange to qualify, the properties must be like-kind or similar in nature. This means that both properties must be used for investment purposes rather than for personal uses.

5) Use of an intermediary. In the process of completing an exchange, the seller is not allowed to receive any of the proceeds from the sale or they will be taxed accordingly. The solution is work with an intermediary who collects the proceeds from the sale of the relinquished property and then disperses the funds towards the settlement of the acquired property.

6) There are clear rules regarding timelines for exchanges. Following the sale of the relinquished property, the seller has 45 days to identify 3 potential exchange properties for purchase. They will send this list of 3 properties to their intermediary for recording in their file. Within 180 days from the sale of the relinquished property, the seller must settle on one of these 3 properties.

7) “Boot” In the event that the seller receives any portion of the sales proceeds from the relinquished property in the form of cash at any point, it is considered “Boot” and it is taxed. If the seller decides to exchange into a property that costs less than the relinquished property, then the balance of proceeds will be given to the seller at the end of the 180 day period by the intermediary and they will be taxed as capital gains.

8) The debt position in the acquired property must match that of the relinquished property to avoid boot. If a seller sells a property for $2 million where they had $500,000 worth of debt, they must then acquire a property worth $2 million or more and put at least $500,000 in debt on the new property to avoid capital gains taxes on boot. If they were to acquire a property for $1.9 million with $500,000 in debt, then they would owe taxes on 100k. If they were to acquire a $2 million property with only $400,000 in debt, they would also owe 100k in taxes.