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INVESTING 101 EDUCATION

The 1031 Exchange Explained

If you’re a new or seasoned real estate investor, you’ll want to know all about the 1031 exchange. This powerful section of the IRS Code is a means by which you can defer taxes, plan your estate or simply build your wealth.

What is a 1031 Exchange?

The 1031 exchange is so named because of its location in the IRS Tax Code. It’s in section 1031 of Title 26, Subchapter O: Gain or Loss on Disposition of Property. Section 1031 is entitled, “Exchange of real property held for productive use or investment.”

According to the IRS, a 1031 exchange is a tax exception that 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.”

In laymen’s terms, a 1031 exchange is simply a way for real estate investors to defer taxes on the sale of real estate. Most real estate investors use the 1031 exchange purely as a tax strategy, although there are other ways to utilize this powerful exception, as discussed below.

1031 Exchange as a Tax Strategy

The 1031 exchange can be used as a tax strategy like this: Say you purchase real property for investment purposes. A few years later you wish to get out of that property for some reason, but you are dreading the taxes you’ll pay on the capital gains. If you happen to be in a high tax bracket, your capital gains tax could undercut any profit you make on the investment.

With a 1031 exchange, you can defer the capital gains tax by moving into another real property investment. With this strategy, you’ll pay zero capital gains tax, and you’ll be able to leverage your equity and down payment into a new—and potentially better—investment property.

In theory, you could defer your capital gains tax until you move into a lower tax bracket later in life, or whenever you’re in a better position to handle the tax bill.

This is the short and sweet version of using the 1031 exchange as a tax strategy, but there are several caveats, so keep reading.

1031 Exchange as an Estate Planning Tool

Another popular way to use the 1031 exchange is as an estate planning tool. This one is especially powerful one if you desire to leave real property assets to your heirs or to help heirs minimize taxes upon your demise. Basically, this is how it works:

You own an investment property and go through one or more series of 1031 exchanges throughout your life. So far, you’ve never paid capital gains taxes on any of those real property exchanges by utilizing the 1031 exchange rules. Rather than defer the capital gains tax, you never intend to pay taxes on those transactions. Your plan is to leave your heirs with the last real property investment(s) in your portfolio.

Upon your demise, your heirs get a stepped-up cost basis. Rather than valuing all the property transactions regarding appreciation, their cost basis is equal to the current fair market value of the property. According to the IRS, your heirs don’t realize any gains. This allows your heirs to sell the property you left them and pay no tax on the sale (or very little if they sell over fair market value).

1031 Exchange as a Wealth Building Strategy

Another way that savvy real estate investors use the 1031 exchange is as a wealth building strategy. This is a fantastic way to potentially build up your investment portfolio into something that figures into the millions.

Here’s an example of how that might look:

You have just $50,000 to invest in a property. You buy a $250,000 investment property with 20% down. After a few years you sell that property and make a $70,000 profit. You utilize the 1031 exchange rules and put 20% down on a better property for $600,000, using your profit plus your original down payment. You repeat this three more times over the years, each time using your profit plus your $50,000 down payment to buy better property with 20% down. After 20 years, give or take, you would have a portfolio equal to nearly $4 million. At any point during that time, you have the option to roll into another property or to take the tax hit. But by the time you hit $4 million a tax hit might not feel so hard!

How to Comply With 1031 Exchange Rules

Now, you’re dealing with the IRS here, so there are rules that go along with the 1031 exchange. It’s vitally important that you comply with 1031 exchange rules. As with anything else tax related, the IRS will be watching to ensure that you play fairly, and they won’t hesitate to audit you if there’s even a whiff of cheating. It’s okay if you get audited as long as you’ve taken every step necessary to ensure compliance.

Hire an Intermediary

There’s nothing in Section 1031 of the Tax Code that says you have to hire an intermediary. But this is a great way to protect yourself while you’re doing 1031 exchanges. An intermediary enables you to keep your hands off the money. Give your money to the intermediary to hold in escrow. Have the intermediary transfer the funds when you buy your property. Have the intermediary accept the funds when you sell your property. This keeps your hands clean so the IRS can never claim you used money from the property sale for anything but another property purchase according to the 1031 exchange terms.

Hold the Property

Section 1031 (2) states, “This subsection shall not apply to any exchange of real property held primarily for sale.” Essentially, this means house flippers need not apply. The 1031 exchange exception only applies to properties purchased for investment purposes; not as a way to make a quick buck by reselling.

The IRS Tax Code is vague regarding how long an investor has to hold real property to comply with 1031 exchange rules. But most financial experts recommend holding the property for a minimum of one year before selling and repurchasing to be on the safe side. This helps to demonstrate that your purchase intent was an investment, not resale.

Demonstrate Investment Intent

You should take steps to demonstrate your intent to use the property to make money as an investment. There are several ways to do this, including:

  • Advertise the property for lease or rent
  • Market with “for rent” signs on the property grounds
  • Rent out the property
  • List the property as a vacation rental on sites like VRBO, HomeAway, etc.
  • Contract with a leasing agent or property manager

Even if no one rents out your property for some reason, you’ve demonstrated your investment intent by advertising it with actions like these. Be sure to retain evidence of your actions, such as receipts, copies of contracts, telephone messages, and photographs.

Exchange Like-Kind

Your current and new property must satisfy the like-kind requirement. The IRS states, “Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”

For instance, it’s okay to move from a duplex into an apartment building, or from raw land to a single-rental house. The like-kind rule can be confusing to the inexperienced, so it’s advisable to seek the counsel of a CPA or tax attorney before moving ahead.

Adhere to Time Restrictions

There are very specific time restrictions attached to the 1031 exchange exception. For example, from the date that you sell an investment property, you have 45 days to identify a potential replacement property or properties. Another time restriction is that you have to receive the new property no later than 180 days after the transfer of the exchanged property. There may be additional time restrictions, which you can discuss with your financial advisors.

Adhere to Identity Rules

When you identify a new property to buy within those 45 days, it can be one property, or it can be a collection of three potential properties that you’re looking at. You don’t need to buy all three or even two, but you can identify three. Another rule is that you have the opportunity to identify up to four potential replacement properties as long as the value doesn’t exceed 200% of the property you’re selling. If the value does exceed 200%, then 95 percent of that value of what’s identified must be purchased. The property identification rules can be complicated, so the assistance of a 1031 exchange expert is highly recommended.

Keep Property in the Same Name

Finally, the last major thing to remember as far as compliance with 1031 exchange rules, is to always keep the property ownership in the same name. For instance, if you buy your first property in your name and then, later on, decide to form an LLC, you won’t be able to use that LLC to buy and sell property if you want it to qualify as a 1031 exchange. It’s okay to use an LLC name, but you have to continue with whatever name you started with.

As you can see, the rules surrounding the 1031 exchange exception are complex. This is not a definitive guide; this is intended to give you a broad overview of the many benefits of the 1031 exchange, as well as the many regulations. If your goal is to acquire many properties, the 1031 exchange is a very advantageous tool to use. As always, consult with your tax attorney or CPA so that you can ensure compliance as well as maximize your real estate investment benefits.