No, it’s not a vague mailing address – wait, it actually might be. But in real estate, a 1031 exchange is a swap of one investment property for another. It allows the deferring of capital gains and depreciation recapture taxes.
What is a 1031 Exchange?
The term gets its name from IRS code Section 1031. IRS Section 1031 allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale. You must do so within certain time limits, in a like kind property or properties that is of equal or greater value.
A 1031 allows a real estate investor to shift the focus of their investing without paying taxes. Thus, you could, for example, exchange a high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another. A 1031 makes this possible.
How do you qualify?
Real estate property held for business use or investment qualifies for a 1031 Exchange. A personal, primary residence does not qualify. Second or vacation homes that are not held as rental properties also do not qualify. However, there is a usage test under Paragraph 280 of the tax code. This may apply to those properties in which case you should consult a tax advisor.
Land under development, and property purchased for resale do not qualify. Personal property like stocks, bonds, notes, inventory property, and a beneficial interest in a partnership are also not considered like kind property.
The type of property being sold and the new replacement property must both be for investment purposes or for productive use in a trade or a business. They must be like kind properties.
Here a few examples of what would qualify as like kind:
- An office in exchange for a shopping center
- A shopping center in exchange for land
- Land in exchange for an industrial building
- An apartment building in exchange for an industrial building
- A single family rental in exchange for a tenants in common (TIC) property
How do you use it?
There are four main types of like kind exchanges investors can choose from.
Simultaneous exchange
A simultaneous exchange occurs when your replacement property (what you’re buying as your new property) and your relinquished property (what you’re selling as the previous property owner) close on the same day, hence why it’s called simultaneous. Any delay, even a short delay, can result in the disqualification of the exchange and full tax liability.
Delayed exchange
The delayed like kind exchange, the most common of all four, occurs when you are selling the property you hold before you acquire replacement property.
In this situation, you as the exchanger are responsible for marketing your property. With that, you must also secure a buyer, and execute a sale and purchase agreement before the delayed exchange can be initiated. Once this occurs, you must hire a third-party, qualified intermediary to initiate the sale of the relinquished property. The intermediary holds the proceeds from the sale in a binding trust for up to 180 days. During this time you should acquire a like kind property.
You have a maximum of 45 days to identify the replacement property and 180 days to complete the purchase. In addition to the numerous tax benefits, this extended timeframe is one of the reasons that the delayed exchange is so popular.
Reverse exchange
A reverse exchange, also known as a forward exchange, occurs when you acquire a replacement property through an exchange accommodation titleholder before you exchange the property you currently own. In theory, this type of exchange is very simple: you buy first and exchange later.
What makes reverse exchanges a little tricky is that they require all cash. Also, many banks won’t offer loans for reverse exchanges. But the timeline works like the delayed exchange, except in the exact opposite direction. You have a maximum of 45 days from the purchase of the new property to identify which property you want to sell and up to 180 days from the purchase to complete the sale of your relinquished property to finalize the exchange.
Improvement or construction exchange
The construction exchange allows you to make improvements on the replacement property by using your exchange equity. In other words, you can use your capital-gains-tax-deferred money to enhance the replacement property, while it is placed in the hands of a qualified intermediary for the remainder of the 180 day period.
What’s next?
While 1031 Exchanges seem simple in outline as above, completion of them may become complex. Ultimately, you should always consult experts. This is no job for a first time investor.
Those experts should be:
- Real estate agent – Seek help from a real estate agent. Preferably one that is experienced with finding 1031 Exchange replacement properties.
- Qualified intermediary – You’ll need a middleman to facilitate your transaction.
- Tax advisor or attorney – Most importantly, a 1031 Exchange is a tax strategy. Even if you hire a great qualified intermediary, their role is not to give you tax advice. Therefore, it’s important to have a qualified tax professional to help guide you through the 1031 Exchange process, as well as the process of filing your tax return.
Brady Miller, CFA is Chief Executive Officer at Trelora, Inc. Brady joined Trelora in August, 2018 as Chief Financial Officer. He moved into his current role later that year and is responsible for all daily operations and growth of the broader real estate business. Prior to joining Trelora, Brady was Chief Financial Officer of Leeds West Groups which is one of the largest, and fastest growing automotive retailers in America. Brady managed their real estate portfolio, financing, human resources, and accounting. He earned a Charted from the CFA Institute in 2016 and holds a bachelor’s degree from the University of Colorado, Boulder where he majored in Finance and Real Estate.