1031 EXCHANGE Flashcards
WHAT IS A 1031 EXCHANGE?
A 1031 exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains or losses or capital gains tax that you otherwise would have to pay at the time of sale.
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
WHAT ARE THE RULES FOR THE 1031 EXCHANGE
The main requirements for a 1031 exchange are: (1) must purchase another “like-kind” investment property; (2) replacement property must be of equal or greater value; (3) must invest all of the proceeds from the sale (cannot receive any “boot”); (4) must be the same title holder and taxpayer; (5) must identify new property within 45 days; and (6) must purchase new property within 180 days.
HOW BENEFICIAL IS A 1031 EXCHANGE?
To understand how beneficial a 1031 exchange can be, you should know what the capital gains tax is. In most real estate transactions where you own investment property for more than one year, you will be required to pay a capital gains tax. This directly levies a tax on the difference between the adjusted purchase price (initial price plus improvement costs, other related costs, and factoring out depreciation) and the sales price of the property. The percentage that’s taxed on your capital gains depends on the tax bracket that you’re in.
FOUR TYPES OF REAL ESTATE EXCHANGES
Simultaneous exchange
Delayed exchange
Reverse exchange
Construction or improvement exchange
SIMULTANEOUS EXCHANGE
One type of 1031 exchange is a simultaneous exchange, which takes place when the property that you’re selling and the property that you’re acquiring close the same day as one another. Keep in mind that this exchange must be simultaneous in order for you to receive the benefits. If the closing of either property is delayed for a short period of time, the exchange could be disqualified, which means that you would need to pay full capital gains taxes.
A simultaneous exchange can occur in three separate ways. The first type of simultaneous exchange is one where you swap deeds with the owner of the other investment property. The second type is a three-party exchange where the transaction between you and the owner of the other investment property is facilitated by a third party called a Qualified Intermediary. Qualified Intermediaries will structure the entire transaction and have training and experience in handling such transactions. Without the help of a Qualified Intermediary, you run the risk of nullifying the 1031 exchange and incurring a large tax burden.
DELAYED EXCHANGE
A delayed exchange is easily the most common 1031 exchange that you can make. When you conduct a delayed exchange, you will be able to relinquish or sell your investment property before you purchase another investment property. This allows you to use the funds from one sale to acquire another property. This type of exchange can’t occur until you’ve marketed your property, secured a buyer, and have executed the sale and final purchase agreement. A Qualified Intermediary will then need to be engaged to retain the proceeds of the sale until a like-kind property is acquired by the seller.
You will have 45 days to identify a new property and 180 days to close. During this period, the profits from the sale of your previous investment property will be held in a binding trust. Again, while the sale of your new property must be completed in 180 days, you will only have 45 days to find the investment property that you wish to buy. This time-frame gives you some leeway when compared to a simultaneous exchange.
REVERSE EXCHANGE
A reverse exchange is unique in that you find and purchase an investment property before selling your current investment property. Your current property will then be traded away. By purchasing a new property beforehand, you can wait to sell your current property until the market value of the property increases.
The main issue with this type of exchange is that the transaction typically occurs with 100 percent cash. It’s also important to understand that the majority of banks don’t provide reverse exchange loans. Keep in mind that the purchase of another property with this exchange means that you will have 45 days to determine which one of your current investment properties are going to be relinquished. You will then have another 135 days to complete the sale.
CONSTRUCTION OR IMPROVEMENT EXCHANGE
A construction or improvement exchange is a type of exchange that allows you to make improvements to the property before the actual exchange takes place. The property will be placed with a qualified intermediary for 180 days, during which you can use the exchange equity to make the necessary improvements. However, there are three separate requirements that you must meet if you want all gains to be free from taxes.
First, all exchange equity will need to be spent as a down payment or by making improvements to the property within 180 days. The taxpayer will need to receive the same property that was identified on the 45th day, which means that it can’t change significantly. Once the property is given back to the taxpayer, it will need to be at an equal or greater value. These improvements need to be made within 180 days.
HOW DOES A 1031 EXCHANGE WORK?
The 1031 exchange process includes the escrow, the accommodator and the 45 day period.
First of all, you have a property that you’re selling and this, we call the downleg. When the downleg sells the funds are going to go into an escrow. An escrow is a neutral third party, whose job it is, is to make sure that both parties execute on the contract of sale of your property. This is important to understand because when your property sells and the funds are released, they cannot go into your name or your bank account if they do they’re now taxable. To get around this, you are required to have another neutral third party known as the accommodator. The accommodator’s job is to hold the funds in their name, not your name while you do your 1031 exchange.
Now that your funds have transferred to the accommodator, the IRS gives you 45 days to identify or pick the properties that you want to purchase.
Once you’ve identified, and you’ve recorded that with the accommodator, you now have an additional 135 days to actually close escrow and take possession of those properties. The 45 day period, plus the additional 135 days gives you a total of 180 days from the beginning of this process to the end. At the end of that, you must have those new properties transferred in your name.
It’s very important to understand these rules. You cannot take those funds into your name in any way, shape or form, or you get taxed. You cannot go past the 45 day period while you identify the property or you get taxed and you can’t go past the 180 day total period in order to take possession of the properties, or again, you get taxed.
WHEN TO DO A 1031 EXCHANGE?
The best time to do a 1031 exchange is when you are in a high tax bracket that would require you to pay a high percentage of federal income taxes, but you want to keep cash on hand in order to keep reinvesting and expanding your real estate portfolio. By deferring the federal income taxes on new properties, you aren’t giving an extra-large portion of your investment capital to the government each year.
There is no limit on the number of §1031 exchanges you can do, so you can keep investing and swapping properties for as long as you like, and then only pay taxes once when you sell your properties for cash. It is also important to consider the attractive nature of §1031 exchanges for estate planning.
REPORTING A 1031 EXCHANGE TO IRS
Every 1031 exchange must be reported to the IRS on Form 8824. This must be completed by the investor and filed with their tax return for the year in which the exchange was completed. The form will ask for descriptions of both/all the properties exchanged, the dates of the sales of all properties, cash received or paid liabilities that were relieved or assumed, and the valuation of any like-kind and other property that was received in the exchange. Failure to report n exchange and/or follow the rules can result in an investor being held liable for the capital gains tax amount as well as other penalties and interest.
