Wondering how to do a 1031 exchange with real estate? Read on to find out more about what a 1031 exchange is, specific rules to keep in mind, and the different types of exchanges.
In this guide, you’ll learn:
Table of Contents
- How to do a 1031 exchange
- 4 Types of 1031 exchanges
- What qualifies as a 1031 exchange
- And what qualifies as like-kind property
What Is a 1031 Exchange?
A 1031 exchange, sometimes referred to as a “Like-kind” exchange, is a method of exchanging properties where you defer capital gains taxes on the sale of an investment property, so long as you purchase another like-kind property using the profit from the sale.
The Benefits of a 1031 Exchange
Why might you want to use a 1031 exchange to sell your investment property?
A 1031 exchange, originating from IRS Code Section 1031, gives you the ability to shift investment properties without incurring tax penalties, which has several additional benefits baked into that.
Let’s say market prices are picking up, as they have been for some time now, and you’re worried about another potential bubble.
Using the 1031 exchange system, you could shift your investment from your current properties to other more stable high-priced real estate to weather the increased risk until the market cools down.
In that case, you’re not just avoiding tax penalties, the 1031 exchange system allowed you to potentially save big time by shifting your investment to more secure real estate, the same way that a stock investor might move some of their money from live stocks over to the S&P or back again.
How to Do a 1031 Exchange
First, how do you do a 1031 exchange?
There are a few rules you need to follow to be able to take advantage of the 1031 exchange rule:
- The properties must only be real estate and not personal or intangible property
- Of a similar value, with the new property needing to have the same or larger value and loan amount than the original.
- And must be like-kind
We’ll explain more what like-kind is later, but for now, let’s talk about the different types of 1031 real estate exchanges.
4 Types of 1031 Exchanges
There are several different kinds of 1031 or “like-kind” exchanges, the most common being:
- Construction (or improvement) exchange
- Simultaneous exchange
- Delayed exchange, and
- Reverse exchange
Below is a quick summary of each of these common types of like-kind exchanges:
1. Construction or improvement exchange
A construction or improvement exchange gives you the ability to make improvements on the new replacement property using the equity from the sale/exchange.
Keep in mind that there are a few rules you need to follow to qualify for a construction exchange:
- The entire equity from the exchange/sale must be spent on improvements OR as down payment by the 180th day of the sales process.
- You, as the taxpayer, must receive “substantially the same property” which you identified by the 45th day of the process.
- The replacement property must be of equal or greater value when it is finally deeded back to the taxpayer, and these improvements must be completed before the title can be transferred back from the intermediary to the taxpayer.
2. Simultaneous exchange
A simultaneous exchange means that both the original property sold and the replacement property close on the exact same day.
This is a bit of a delicate one, as the exchange must happen to such exactness that even a delay in wiring funds can disqualify the transaction and immediately apply the tax dues.
There are several different ways a simultaneous exchange can be done, only one of these is required for the exchange to qualify as a simultaneous exchange:
- Deed swap: You and the other party perform an exchange of deeds.
- Third part exchange: A third party facilitates the simultaneous exchange.
- Qualified intermediary: Another version sees an intermediary who oversees the exchange.
3. Delayed exchange
In this type of exchange, the relinquishing of the original property you owned and the acquisition of the new property is “delayed”, hence the name.
In this type of exchange, you’re responsible for securing a buyer and executing the sale in its entirety. Once that’s done, hire a qualified intermediary to begin to initiate the sale and hold the proceeds from the sale in a trust until you acquire a new like-kind property.
This is, by far, the most common type of 1031 exchange performed by investors. That’s likely because the window of time you get by using this kind of exchange gives investors a lot of flexibility that you don’t get from other types of exchanges.
4. Reverse exchange
A reverse exchange, sometimes called a forward exchange, is essentially the opposite of the previous delayed exchange: you buy the replacement property first then sell the relinquished property after.
To use this type of exchange, the purchase of the new property must be done with all cash. So, decide which of your properties is the one you’re going to relinquish (within 45 days) while that new property is “parked” until the exchange is complete.
Additionally, you have a 180-day period to sell the relinquished property, otherwise, the exchange is canceled and you’re responsible for the tax dues.
What Qualifies for a 1031 Exchange? 1031 Exchange Rules Explained
So, now that you know more about how a 1031 exchange works, how do you know what qualifies for a 1031 exchange so that you can take advantage of it?
Below are the 7 guidelines you have to follow to qualify for a 1031 exchange of any kind:
- Must be like-kind property
- Has to be investment or business property
- Must be greater or equal value
- Can’t receive “Boot”
- Must be same taxpayer (referring to the person who sells the relinquished property and the person who purchases the new property)
- You have a 45-day window to identify the replacement property (except in the case of simultaneous exchanges)
- And a 180 day purchase window
Let’s break down each of these guidelines in a bit more detail:
1. What qualifies as like-kind property
Arguably the most important guideline as it’s the one that requires the most explaining is the like-kind property rule.
To qualify as a 1031 exchange, the property being purchased must be “like-kind” the relinquished property you’re selling.
What that means is both properties must be “of the same nature or character, even if they differ in grade or quality,” according to the official IRS website.
That means both properties must be used for the same purpose, which means virtually any two properties will qualify as like-kind as long as they’re commercial/business (no personal property).
This stretches pretty far, as even an office building and rental property qualify as like-kind property.
The replacement property can even be multiple properties, believe it or not. So, if the relinquished property is a rental building and the replacements are two commercial buildings, that also qualifies.
2. Investment or business property: Can you use a 1031 exchange to purchase a primary residence?
We touched on this above, but a 1031 exchange only applies to investment or business property.
According to the IRS, “Under the Tax Cuts and Jobs Act, Section 1031 now applies only to exchanges of real property and not to exchanges of personal or intangible property.”
In other words, you can’t use any 1031 exchange method for personal property.
For example:
- If you want to sell a personal residence for a property for a restaurant you’re launching, you can’t use a 1031 exchange
- Or, if you want to sell a rental property you own to purchase a personal residence, you can’t use a 1031 exchange
3. Must be greater or equal value
To qualify for 100% tax deference, the net market value of the property you’re purchasing must be of equal or greater value than the one you’re relinquishing for sale.
Keep in mind that this applies to both the value of the property as a whole and the mortgage. So, if you’re selling a property worth $1.2 million and the mortgage was $750,000, the value of the new replacement property must be at least $1.2 million and the mortgage $750,000 or higher.
One important point to note here is that fees apply toward that valuation, such as inspection fees and broker fees, so make sure to include them in your calculation.
4. Can’t receive “Boot”
“Boot” refers to the difference between the relinquished property you’re selling and the replacement property you’re buying.
To be clear, a sale can still qualify as a 1031 exchange if the property is of lesser value (i.e. you’re receiving Boot). However, you’ll have to pay capital gains tax on that difference.
For example: If you sell a property for $500,000, but purchase a replacement property in exchange for $450,000, you would need to pay capital gains tax immediately on the $50,000.
5. Same taxpayer
To qualify for a 1031 exchange, the original property and the new one you’re purchasing must both be under the same name.
That means if you’re the one selling the property, your name must have been on the relinquished property as well as on the purchase of the new property, they can’t be two different people.
6. 45-Day identification window
From the moment you close on the sale of your original property, you have a 45-day window to select 3 potential like-kind exchange candidate properties.
You don’t need to come to a decision yet. However within this relatively short window, you must have narrowed down to your top 3 candidates.
This can be tricky because you ultimately must choose one of these three properties and can’t change your mind without incurring capital gains.
How many properties can I identify with a 1031 exchange? (The 200% Rule exception)
There is, however, an exception to this.
If you’re having trouble identifying your top 3 candidates, the “200% Rule” states that you can choose 4 or more candidates. However, that’s only so long as the total value of those properties does not exceed 200% of the property you sold.
7. 180-Day purchase window
Lastly, as part of the 1031 exchange process, you have a 180-day window to complete the entire exchange process.
You must complete the exchange in full from, identifying the exchange property and finalizing the purchase, by the end of the 180-day window. This window begins once the original property is sold or the due date of the income tax on the year it was sold, whichever comes first.
1031 Exchange: A useful tool for real estate investors
The 1031 exchange rule is a useful tool that real estate investors can use to gain additional flexibility when buying and selling property.
Whether you’re wanting to:
- Shift your investment to a developing area
- Your current investments aren’t working out
- Or any other reason
A 1031 exchange could be exactly what you need to improve your investment forecast, in addition to the tax deferment.
There are several rules you must follow to take advantage of a 1031 exchange. However, most are relatively simple and easy to qualify for.
So, if you plan to utilize the 1031 exchange rule, make sure to choose your new property wisely and plan the process well in advance. For instance, make sure the sale occurs before or at the same time as the income tax is due for that year. Otherwise, you’re narrowing your already tight 180-day window down further.
Keep in mind: this is a complex rule that has many intricacies. So, take the time to really study it in detail to make sure you’re taking all the right steps.
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