As an investor, there are a lot of ways that you are going to deal with taxes throughout your work. Investors have a lot of tax rules that they need to follow, but they also have a lot of tax rules that they can take advantage of in order to make the biggest profit possible.
For many investors, using a 1031 exchange rental property swap can be a great way to free up more capital to work on investments. Additionally, the exchange can be used to change up what kind of investment properties you are currently working with.
However, many investors are still asking: How does a 1031 exchange work? Investors that have heard of this IRS tax code but never used it can find it overwhelming to set up at first, but it’s a great thing learn and understand so that you can get the biggest benefits possible.
Today, we’re sharing our guide to the basics of 1031 exchange. Once you understand more of Section 1031 exchange rules, you’ll be able to see if this type of transaction can benefit you or your business.
A Table of Contents for 1031 Tax Free Exchange Rules
- What is a 1031 Exchange?
- 1031 Tax Free Exchange Rules & Requirements
- When To Do a 1031 Exchange
- Three Types of 1031 Exchanges
- How to Do a 1031 Exchange: Examples
A 1031 exchange, also known as a like-kind exchange, is a type of property sale where you can defer paying taxes for the sale by trading your property with someone else’s similar property. Rather than being taxed for the sale of your property, the new property is a “like-kind” property and is considered to be a continuation rather than a change of property.
What does this mean for you?
This means that the taxation of your gain that you would have got from selling your property is postponed. Rather than paying taxes on your profits, you own a new property instead.
When using 1031 tax codes, you could continue to exchange properties for as long as you want. Ultimately, however, you would need to pay the taxes on these properties. When you decide to sell one of the like-kind properties, you would need to pay relevant taxes as well as all of the taxes that were tax-deferred throughout your exchanges.
The 1031 IRS Code
The 1031 of the IRS Code reads like this:
- “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like kind, which is to be held either for productive use in a trade or business or for investment.”
There are a lot of rules that must be followed when you are doing this type of exchange to defer your tax requirements. Today, we’ll break down the requirements so that you can get a clear understanding of what does and does not work when working on a 1031 exchange.
1. 1031 Exchange Timeline
There is a strict 45/180 day set of guidelines in place when it comes to exchanges. Once you sell a property, you have exactly 45 days to find a property of equal or greater value to exchange for. You then have either 130 days from the end of the 45 day period or 180 days from the original property sale date to acquire the like-kind property.
2. “Like-Kind” Rules
The property must be a “like-kind” property when exchanging. Like-kind property is any property that has been held for similar investment or business purposes. Rather than showing similarity in quality, the properties must show similarity in nature or character.
3. Investment Rule
It is not permissible to sell a primary residence to purchase an investment property through the 1031 rule. Likewise, you cannot sell an investment property to purchase a primary home with this rule.
4. Debt & Equity in the 1031 Exchange
Let’s say that an exchanger sells a property for $300,000. $150,000 of that property was equity, while $150,000 was debt. The exchanger would still need to purchase a property worth $300,000 or more. Additionally, all equity must be used, and all debt must be replaced in order to completely defer capital gain taxes.
If there is any difference, taxes can be paid on the difference, which is known as a “boot.”
5. Cash Cannot Be Received
The main exchanger can at no time receive any cash from the like-kind property exchange. If they do receive cash, a taxable event will be triggered, and you will have to pay taxes. Instead, a qualified intermediary (also known as a QI) must be used if any cash will be required.
6. QI Requirements
The QI must be an independent third party that is in no way linked personally or professionally to you or the other exchanger. They hold the sales proceeds and also purchase replacement property on your behalf. Ideally, you should work with a qualified and insured QI that works professionally.
Now that you know more about the 1031 exchange and what rules apply to this type of real estate transaction, you might still be wondering when this situation would be beneficial for you to consider.
When working as an investor, these are some of the most common times that you may want to consider using a 1031 exchange:
- You want to move on to a different type of investment property to diversify your assets.
- You want to move from investment real estate to a managed property to do less of the direct leg-work.
- You are hoping to consolidate properties into one or divide one property into separate assets.
- You want to reset depreciation (we will explain this in greater detail below).
No matter what situation you are in, doing a 1031 exchange usually has one main benefit: more free capital. As you can defer the gains tax, you have more capital available at the815isb moment to use for investing.
Depreciation & Like-Kind Exchanges
As we mentioned, some investors carry out a like-kind exchange in order to reset the depreciation on their property.
Depreciation can be described as the percentage of investment property cost that you are able to write off each year because of wear-and-tear at the property. When you sell a property, the capital gains taxes are calculated on what is known as net-adjusted basis. This is the property’s original purchase price, plus improvements, minus depreciation.
In cases where the property ends up selling for more than the depreciated value, you may need to then pay more taxes on your taxable income as the difference will be added to your income.
Using a 1031 exchange to reset depreciation on homes that have been kept in very good condition can help you to avoid this addition to your taxable income. The depreciation used will still be affected on your tax deferred one day, but it will not be as severe.
1031 exchanges can be done in a few different ways, and each of those methods has its own set of rules, timing, and other details. Let’s take a look at how each of them works.
Basic delayed 1031 exchanges must be carried out within 180 days. This is the most common type of like-kind exchange that you may encounter.
Here’s what happens in this type of exchange:
1. An investor closes on an investment property that they are selling.
2. Within 45 days, they find a replacement property.
3. Within 180 days of the original closing, the investor closes on the new property.
This type of exchange must be handled by a qualified intermediary. As explained above, a QI is a third party that is uninvolved with both parties. This QI holds the proceeds from any sales in an escrow account. Then, the funds are used to purchase the other property and carry out the exchange.
The replacement property in a delayed exchange must meet one of the following rules:
- Three Property Rule
The investor finds up to three different potential properties to purchase during the identification period of 45 days. The total fair market value of the properties does not matter for this rule.
- 200% Rule
The investor can choose an unlimited number of properties to consider for the exchange as long as the total value is not more than 200% of the original property’s value.
- 95% Rule
The investor can choose to exchange as many properties as they want to. The only rule is that they get at least 95% of the value of those identified properties by the end of the 180-day exchange period.
In this type of exchange, one of the properties that gets exchanged can be renovated or newly constructed. That being said, these exchanges still follow the 180-day time limitations. This means that all construction to the property must be done by the time the transaction is completed.
If the improvements are not complete by the time that the exchange window closes, those improvements are considered to be personal property and need to have any relevant taxes paid on them immediately.
Reverse exchanges happen when an investor like you owns the replacement property before you get rid of the property that you are exchanging.
For this type of exchange to work, the property must be transferred to a qualified intermediary or titleholder. Then, an agreement should be signed. You then have 45 days to find an appropriate exchange property. From there, you will have the usual 180 days to complete the exchange process.
To truly understand how the 1031 exchanges work in practice, it will probably be helpful to look at a few example cases. These cases illustrate how like-kind exchanges work and how they might be beneficial for your investing work.
Example 1: Basic Exchange
Robert owns a rental house that has an adjusted basis of $100,000. Another investor has property that is also being held for investment. The total fair market value of both properties is around $200,000. Robert and the other investor change properties, and Robert’s new property also has a basis of $100,000.
Example 2: Deferred Tax Payment
Let’s continue with example 1 to look at how the tax-deferred aspect of this type of exchange usually works. Four years have passed, and Robert has decided to sell the property. Robert sells it in an all-cash transaction for $450,000. After the sale, Robert has to pay the tax on the sale as well as the deferred tax from the original trade transaction.
The total gain on Robert’s property is $350,000 ($450,000 sales price minus original basis of $100,000). Tax would need to be paid on this gain.
There is a way that Robert could avoid paying this tax. If he owned the property for five years and lived in it for two, he could then turn it into a personal residence before selling it to exclude the gain tax. Most investors, however, will find this impractical and will instead pay the capital gain tax as needed.
Example 3: Cash Exchange
As we mentioned, most investors do not want to swap a property for another property. One of the owners typically wants to be paid cash for their property. And it is still possible to use the 1031 exchange to do just that.
Michael owns a single-family home that he rents out. He paid $200,000 for the property, and it is now worth $300,000. Rather than selling the property, he wants to exchange it for another property. Michael contacts Bob who is a qualified intermediary.
Bob finds an apartment building that is for sale. The current owner of the apartment building does not want to exchange properties, but that is okay. Bob buys the apartment building for $300,000 cash, and then he and Michael use the rules of section 1031 to exchange properties.
Bob gets paid for his work in the transaction, and then he sells Michael’s original property to repay the money he used to buy the other apartment building. This is how exchanges can be done when only one party wants to trade properties.
Now that you know more about 1031 exchange rental property works and how it might benefit you, this is an investment technique that you can take into your future business.
Beyond these rules, however, states may have additional rules that regulate how QIs and other parties involved in like-kind exchanges work. For example, 1031 exchange California rules restrict the number of exchanges that you can do in a specific period of time.
Be sure to research the specifics of your local code to use in addition to the 1031 tax code. When done right, you can cut yourself a great deal!