If you are a real estate investor, aspire to be an investor one day or are a licensed agent or broker who works with investors, you should understand how a Section 1031 exchange works.
Most investors and agents have heard about Section 1031, but few actually take the time to understand all the requirements you must satisfy to utilize Section 1031 of the Internal Revenue Code to your advantage. Not knowing the vital details could cost you or your client thousands in capital gains taxes. As a real estate broker and investor myself, it is perplexing to me how few agents I encounter take the time to learn these details; you should at least inform your clients about the option to utilize a 1031 exchange when they are considering a sale of their investment property.
My family has been investing in real estate for decades, and over the years, we’ve successfully utilized 1031 exchange a number of times. Based on both my family’s experiences as investors and my experience as a broker representing investors, I’ve outlined a few key points and tips all investors, agents and brokers should be aware of when it comes to 1031 exchange rules.
1. Tax-deferred doesn’t mean tax-free. This is a common misconception: A 1031 exchange does not equate to tax-free gains. Rather, a 1031 exchange allows you to postpone paying tax on the gain earned from selling an investment property if you reinvest the proceeds in similar property per Section 1031 of the Internal Revenue Code.
2. Connect with a 1031 intermediary. One of the most common and costly mistakes investors make when it comes to 1031 exchange is not connecting with a 1031-qualified intermediary prior to close of escrow on the exchange property. To qualify for a 1031 exchange, you must designate a 1031-qualified intermediary and have the funds from your exchange property wired to their escrow account directly as opposed to your personal account. If you have the proceeds wired to your business or personal account and wait to start looking for an intermediary after close of escrow, you are too late, and your capital gains will now become taxable.
3. There is a 45-day identification period for the replacement property. The replacement property must be identified within 45 days from close of escrow of the relinquished property. This identification must be in writing to the qualified third-party intermediary who holds the proceeds from the sale of the relinquished property. Because of this short time frame, investors should begin looking for options during the escrow and due diligence period for their relinquished property as opposed to waiting until after close of escrow.
4. You can identify and/or acquire multiple replacement properties. The IRS allows you to identify up to three potential replacement properties within this 45-day window. You can also relinquish one property and use those proceeds to purchase two or three properties.
5. There is a 180-day closing period. You will need to close on the replacement property within 180 days following close of escrow of the relinquished property. Given this, if you are concerned about qualifying for financing, it may be in your best interest either to work with a mortgage broker who has access to multiple lenders or to inquire directly with at least two commercial lenders in case one falls through. When it comes to commercial real estate loans, the borrower does often have to pay a fee to a broker, but peace of mind and not risking a taxable event is often well worth it.
6. The boot is taxable. If the purchase price of your replacement property or properties amounts to less than the sale price of the relinquished property, the difference is known as the boot and is taxable. This boot could be in the form of cash or debt and is subject to capital gains tax.
7. Like-kind exchange is necessary. Properties involved in 1031 exchange are required to be of like kind, although this has a broad definition. Most real estate is like-kind to other real estate. For example, property improved with a residential rental home is considered like-kind to an office building, retail property, industrial property and even a multifamily complex. The key is how the properties are used: Both relinquished and replacement properties must be used for investment purposes, so you cannot exchange an investment property for a personal residence. However, a replacement property may be converted to a personal residence later on; typically, a two-year hold as a rental property is recommended to avoid issues.
8. The same names must be used on both titles. The taxpayer rule states that the name or names, whether business or personal, listed on the relinquished property’s title must match the name or names acquiring the replacement property. This is important to note as this rule does include spouses if only one spouse was listed on the relinquished property, meaning that adding the other spouse to the replacement property may disqualify the property from the 1031 exchange.
Ultimately, these are just a few of the facts so I strongly recommend that you consult both an experienced 1031-qualified intermediary and your tax advisor if you have any questions or concerns about your specific situation and how to make a Section 1031 exchange work for you.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.