A 1031 tax-deferred exchange makes it possible for investors to build their real estate portfolio with “TAX-FREE” dollars. While it is a tax-deferral (pay it later) strategy, there are ways to completely avoid the tax, since you can do many exchanges during your lifetime - and thus never pay TAX AT ALL!
This blog is going to be, well... a little bit more than our usual quick bite chunks of knowledge. You can KEEP a lot of money in your pockets and GAIN a lot of time growing your investments superfast. So just take a deep breath & read the whole darn thing, you’ll thank and love us later!
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So, What Is A 1031?
Well it is one of the sexiest, most lucrative parts of your Internal Revenue Code Sections, but most people never get beyond 401(k) and it is also a powerful estate preservation tool (=avoid paying tax when you die –yep they’ll come for you even then…). Thanks to IRC Section 1031, a properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes.
IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
What the above statement actually suggests is that tax-deferred exchanges make it possible for investors to legally defer capital gain taxes as well as facilitate significant portfolio growth and increase returns on investment. In other words a l031 Exchange is a transaction in which a taxpayer is allowed to exchange one investment property for another one (likewise or bigger in value) by deferring the tax consequence of a sale. The transaction is legally authorized by the IRS Code.
Why Does It Matter?
Essentially, with your first exchange you create an I Owe You (IOU) to the IRS and each time you do another exchange, you add to that IOU. If you sell a property without doing a 1031 exchange, some or all of that IOU will have to be paid to the IRS. Using 1031 exchanges, you have the opportunity to build your real estate portfolio using pre-tax dollars – creating a larger portfolio and greater cash flow. The ultimate strategy is to defer, defer, die & never pay.
picture credit: triplenetgateway
Because you get to keep all of your hard earned money and invest it all in something bigger thus now making you even more money faster (keep it + grow it + faster).
Let’s talk hard cash (1):
For example, let’s assume that you want to sell your commercial property (Duplex) for $600,000 (with thanks to market appreciation), which you bought for $200,000 as an investment. You know that selling this property will generate a $400,000 capital gain that is taxable anywhere between 15 – 20% (depending long or short term gain and tax brackets) which adds up to $60.000 or $80.000 that you keep in your pocket. If you do a section 1031 exchange, you can defer this capital gains tax by replacing the property with a “like-kind” property: another property that is similar in nature to the one you are selling. So now you can use the whole $600.000 as a down payment for a much bigger apartment complex that will make you even more monthly cash flow so you get even bigger returns on your money. It is like an interest free loan from the government; you can increase the principal by doing multiple exchanges and if done properly never repay.
How 1031 Works In 4 Steps
Step 1: Decide to go for 1031
Once you decide to go for a 1031 exchange, it is important to contact a Qualified Intermediary before closing escrow on your current investment property. To facilitate the 1031 exchange, you will want to insert special clauses referring the 1031 exchange in the Purchase & Sale Agreement for your "relinquished property" (=property to sell).
Step 2: Sell your Property
The Qualified Intermediary will hold the capital gains “proceeds” (=revenue, gains) from the sale during the exchange period. Be vigilant that any money you receive, such as a wire from escrow to your personal bank account, or even an uncashed check for any part of the sale, this money would become irreversibly taxable.
Step 3: Identify Properties
After the qualified Intermediary receives the proceeds from the sale of your investment property, you can work with a broker, real estate agent or an investment advisor to identify "suitable replacement properties" (properties to buy). We'll get to what these are in a sec.
Step 4: Buy New Property
After you have decided which of the potential replacement properties to buy, your Qualified Intermediary will forward the funds for closing.
Time Restrictions On A 1031 Exchange
There are very strict time limits for the identification and acquisition of the replacement property. Potential replacement properties must be identified by midnight on day #45 after the close of escrow on the relinquished property, and the replacement property must be acquired by midnight of day #180. The exchange period includes weekends and holidays, and there are no exceptions.
The day after the close of escrow on the relinquished property is day #1.
#45 day after the close
The countdown starts the day after closing and are calendar days. If the 45th day falls on a holiday, that day remains the deadline for the identification of the new properties. No extensions are allowed under any circumstances. You must have entered into a contract by midnight of the 45th. A list of properties must be furnished (supplied, given) and must be specific showing the property address, the legal description or other means of specific identification.
3 rules for suitable replacement properties:
Up to 3 potential new properties can be identified without regard to cost. Preferable equal or higher fair market value to get the full 100% tax deferred.
If you wish to identify more than three potential replacements, the IRS limits the total value of all of the properties that you are identifying to be less than double the gross sale price of the relinquished property sold. This is known as the 200% rule. As a result, the logical rule for investors is to keep the list to three or fewer properties. It is the responsibility of the qualified intermediary to accept the list on behalf of the IRS and document the date it was received however, no formal filing is required to be made with the IRS.
The 95% exception rule allows you to identify more replacement properties than allowed under the first two identification rules. There is no limit to the total number or total value of identified replacement properties under the 95% exception as long as you actually acquire and close on at least 95% of the total fair market value identified.
#180 day after the close or 6 months rule
This rule is simple and straightforward. Section 1031 requires that the purchase and closing of one or more of the new properties occur by the 180th day of the closing of the old property. The property being purchased must be one or more of the properties listed on the 45 day identification list. A new property may not be introduced after 45 days. These time frames run concurrently, meaning when the 45 days are up you only have 135 days remaining to close. Again there are no extensions due to title defects or any other exceptions. Closed means title is required to pass before the 180th day.
The Rules Of The 1031 Game
Rule 1: Like-kind Properties
An investor must follow three basic 1031 exchange rules. First, the replacement property must be like-kind to the relinquished property. Generally, real estate held for business or investment purposes in the United States is considered "like kind,” including commercial and residential property. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property and equal or greater than in value. Vacant land will always qualify for 1031 treatment whether it is leased or not.
Like-kind relates to the use of properties. As a result, the old property as well as the new property, must be held for investment or utilized in a trade or business.
The following types of properties are representative of those that will generally qualify as like-kind real property:
Single-family residential properties
Multi-family residential properties
Commercial office buildings
Retail shopping centers or strip malls
Industrial warehouses
Vacant, undeveloped, or raw land