Trading Places — A New Look at 1031 Exchanges
The tax code first authorized 1031 exchanges in 1921. But now, skyrocketing property values coupled with the rising popularity of real estate investments have many people taking a new look at an old tax provision.
The basics
A 1031 exchange, also called a like-kind exchange, is a strategy that can be used to defer taxes when you want to replace one business or investment property with another. Because a 1031 exchange allows you to defer taxes on your real estate gain, you’ll be able to reinvest the full appreciated value of the property you’re giving up in a more expensive and desirable property.
For example, let’s say you own a piece of land that has a basis of $200,000 (your cost), and a fair market value of $400,000. If you were to simply sell your land and buy a rental property to replace it, you would owe tax on your $200,000 gain. Assuming a 15% capital gains tax rate, you would owe $30,000. But with a 1031 exchange, your tax obligation would be deferred (until you later sell your new property), enabling you to reinvest that $30,000 in your new rental property instead of sending it to Uncle Sam.
Partial 1031 exchanges are also possible, but keep in mind that any proceeds that aren’t reinvested in another property may be subject to tax.
Identifying properties
There are many complicated rules you must follow to successfully complete a 1031 exchange. That’s why you’ll need help from a qualified real estate attorney or tax professional when exchanging real estate or investment properties. There’s no way to cover all the rules here, but let’s take a quick look at a few of them.
One major rule you must follow concerns the kinds of property you may trade. According to the IRS, all properties involved in a 1031 exchange must be of “like-kind.” Although they don’t have to be identical, these properties do need to be similar in nature or character, and they must be held for business or investment use, not for personal use. In addition, the property you’re receiving must be of equal or greater value than the property you’re giving up. Many kinds of property may be eligible for a tax-deferred exchange, including office buildings, single-family rental homes, apartments, improved and unimproved land, and shopping centers. Vacation homes may also qualify for exchange if they are rented out, and not used mainly for family trips.
There’s some bad news for those hoping to turn a quick profit in a hot real estate market, though. Because property involved in a 1031 exchange must be held for investment purposes rather than for resale, a “flipped” property (one bought and then quickly sold by an investor for profit) will generally not qualify.
Look, but don’t touch
The most common type of 1031 transaction is a deferred exchange in which you give up your original property before closing on a new property. With this type of transaction, IRS rules state that during the time you’re looking for a replacement property, you can’t touch the proceeds from the property you’ve given up. To ensure this, a 1031 exchange generally involves executing a written exchange agreement with a qualified intermediary, such as a bank, trust company, or attorney, that you pay to handle the transaction. The intermediary is responsible for keeping the proceeds from the first property separate in an escrow account, then reinvesting them in the replacement property. The intermediary may also help you locate replacement properties, if necessary.
Another major rule you must follow is that once you give up your original property, you must identify, in writing, up to three potential replacement properties within 45 days (you have the option of identifying more properties, if their total fair market value is not more than twice the value of your original property). In addition, you must close on one of these replacement properties within 180 days of the date you gave up your original property, or by the due date of your return for the tax year in which the property was transferred, whichever is earlier.
Final thoughts
A 1031 exchange can be a powerful strategy for investors and business owners who want to avoid huge tax bills when buying and selling property, so it’s one worth checking out. But make sure you contact a qualified professional who can help you navigate the intricate rules that apply.