If you own an investment property but you’re hesitant to sell because of the tax bill, a 1031 exchange might be perfect for you. The 1031 tax-deferred exchange is often viewed as a “swap out” of the existing property for a new one without incurring capital gains. In reality, this exchange is much easier than a swap. In fact, it might be nothing more than a sale and a purchase.
There are a lot of details and deadlines that must be met for this strategy to work, and we walk through each piece of it below.
Social Media Is Buzzing Over 1031s
If you spend time on the internet, you’ve probably seen some guru talking about the tax advantages of investing in real estate. They might exaggerate the benefits, but they’re not wrong. Real estate comes with unique tax loopholes, and one of the most powerful is the 1031 exchange.
The purpose is to defer your capital gains on a piece of real estate. Whether it’s commercial or residential, as long as it’s an investment, you can defer the capital gains on that property by selling it and identifying a new property that is worth at least $1 more in value than the previous property within 45 days.
As an investor or real estate developer, this is important because capital gains on real estate can be quite large. For something that you’ve owned for many years and has experienced appreciation, the tax bill can be an unfortunate surprise.
The IRS says that properties must be “like-kind” to qualify for the tax benefits, but they’re fairly lenient when it comes to what qualifies. A commercial building could be exchanged for a plot of land, or a residential investment property can be exchanged for an industrial complex. As long as you aren’t swapping a property for a plane, most transactions could meet the like-kind qualifications.
Nuts and Bolts of the 1031 Exchange
Keep this key point in mind: The Section 1031 tax-deferred exchange is nothing more than a sale and a purchase. To clarify how this works, think of four parties:
- The seller of your property (you)
- The buyer of your property
- The seller of the property you are going to buy as your replacement property
- The qualified intermediary who makes your sale and purchases qualifies for tax-deferred treatment
Here, in a nutshell, is what happens:
- You hire an intermediary.
- You don’t touch the money.
- You sell to the buyer, and the intermediary holds the cash.
- You buy your replacement property, using the cash that the intermediary holds.
The qualified intermediary is an individual or entity with whom you have not had a business relationship of any sort within the last two years. This means your accountant or lawyer is not going to pass muster as an intermediary.
Remember: As you engage with an intermediary, you need to protect yourself. Get paranoid. Ask yourself what will happen if the intermediary steals your money or goes bankrupt. Can an inexpensive insurance policy buy protection? Is a bond available? What does the intermediary offer to protect your money?
The Ideal 1031 Strategy
In an ideal world, an investor would keep 1031 exchanging their properties without paying capital gains tax until they ultimately pass on, and then their heirs are able to sell the property with zero capital gains due to step up in basis at death.
However, even without death, you can either pay 15% to 23.8% now on capital gains (with a net investment income tax surcharge at 3.8%) by selling without a strategy. On the other hand, you can just kick the tax can down the road and see what happens in the future — and this is the general idea behind 1031 exchanges.
If you were to sell a property, you would be required to pay capital gains tax, but the 1031 strategy allows you to defer the tax bill and hope you can reduce your tax burden in the future. Most investors don’t want to incur a huge tax bill in the middle of their career which is why the 1031 exchange is so powerful for those in their wealth-building phase.
Time Limits for the Exchange Are Set in Stone
Section 1031 imposes strict time-limit rules that you absolutely, positively must meet. No excuses.
Start date. The trigger date for the Section 1031 exchange starts with the “initial transfer date.” This is the date you close the sale on the property you are selling (the relinquished property).
Identify date. You must formally identify your possible choices of the replacement property on or before the 45th day after the initial transfer date.
Close date. You must have the identified replacement property titled in your name within the shorter of:
- 180 days after the initial transfer day, or
- the due date of your tax return (which you can extend).
You can always get the full 180 days, but if your exchange closes after October 17 of a tax year, you must file an extension to avail yourself of the full 180 days.
Example:
Your exchange’s initial transfer date is December 1.
Your 180 days expire May 30, but your tax return is due April 15.
If you want the May 30 date, you simply file an extension.
Biggest Key to a Successful Utilization of 1031: Work with a Title Company That Knows What They Are Doing
To successfully complete a 1031 exchange, there’s a lot of paperwork that has to be properly filed. You want to bring in professionals to assist, and this would include an experienced title company or a lawyer to make sure that all required steps are being followed.
Prior to selling your current property, you should already have other property identified for purchase because you typically have to close on the next property within 45–180 days.
To ensure that deadlines are met, create a roadmap outlining what needs to be done:
- Locate an experienced professional to assist with transaction
- Sell existing property
- Identify new property (must be within 45 days of sale)
- Close on new property (within 180 days of sale)
A lot of people tend to rely on their realtor to help with a 1031 exchange, but this can be a costly mistake. Why? Because their goal is to get a transaction closed so they can get paid. This isn’t necessarily a bad thing, but they might not be versed in the 1031 process and could miss crucial deadlines or tasks.
For example, a common mistake when executing a 1031 strategy is exchanging the existing property for a property of lesser value. When this happens, the difference between the values of the two properties is subject to taxation. This difference is also known as “boot.” To avoid a surprise tax bill, you need to be aware of the intricacies of this strategy, and an experienced professional can help clarify what needs to happen.
It’s recommended to talk with a title company, your CPA, or your financial advisor to see who they would recommend to spearhead this effort. Title companies with experience utilizing this strategy may be able to handle the transaction and details of the deal themselves, reducing the number of cooks in the kitchen and keeping the process as smooth as possible.
Conclusion
1031 exchanges are a powerful real estate strategy. However, people often make the mistake of acting like they’ll never have to pay taxes on this money.
Although intermediaries have been around for years and have experience that will help you with these transactions, make sure you have some protections for your money. Crazy things happen. Intermediaries go broke. You need to make sure that your money is protected in case something like that occurs.
Also, it’s important to remember that the tax liability is DEFERRED, not ELIMINATED.
A 1031 exchange is not a reduction strategy, but a deferral strategy — and it must be used strategically and proactively to ensure that the full benefits are being absorbed. If you own business, rental, or investment real estate, decide whether you want to pay taxes when you dispose of your properties. In most cases, deferring taxes beats paying them.
Remember: You have to identify a property within 45 days and close on it within 180 to qualify for the exchange, and the property can’t be a primary residence.
Here at TreMonte, we can help you figure out if your situation would benefit from 1031 exchanges, and how to do so properly. Reach out to a member of our team today!