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A 1031 exchange, also known as a like-kind exchange, can be a real estate investor’s best friend. Especially if you’re in it for long-term gains. If you sell a property and use the proceeds to buy another investment property, you pay no taxes on the sale of the first property. Even if you made a profit of millions of dollars.
Of course, like with most real estate tax topics, there’s more to the story. Before initiating a 1031 exchange with an investment property, it’s important to know what you’re getting into. Be sure to check out our guide to 1031 exchanges and read through this list of frequently asked 1031 exchange questions.
What is a 1031 exchange?
A 1031 exchange allows an investor to sell a real estate asset and purchase a "like-kind" asset without paying capital gains taxes on the sale -- even if they made a massive profit. The idea is that there's no taxable event if the investor didn’t receive any monetary benefit from the sale.
To be clear, you'll eventually pay taxes on the sale of an investment property. You’re simply deferring the taxes while you hold another investment property.
When completing a 1031 exchange, the profit you make reduces the cost basis of the newly acquired property. That means the deferred capital gains tax on the property you sell will become due when the replacement property is sold. Unless you complete another 1031 exchange upon that sale.
However, if you don’t cash out, 1031 exchanges can allow you to indefinitely defer capital gains taxes on investment properties.
What is a like-kind property?
According to the IRS, the property you acquire in the process of a 1031 exchange (the "replacement property") must be of "the same nature or character" as the property you sell (the "original property").
However, it’s important to know that this is a very broad definition. It essentially means that you can exchange an investment property for virtually any other type of investment property. For example, you can sell an apartment building to buy another apartment building. But you can also sell an apartment building and buy an office property.
It doesn’t even need to be a building. If you sell a building and buy undeveloped land, it could qualify for a 1031 exchange. As long as you'll hold the replacement property for investment, most property types qualify.
The most important thing to know is that personal property is excluded from 1031 exchanges. You can’t sell an investment property, buy a property you intend to live in, and avoid paying capital gains tax on your profits.
What taxes are due upon the sale of an investment property?
Two main types of taxes can be due upon the sale of an investment property: capital gains tax and depreciation recapture.
Capital gains occur when an asset is sold for more than you paid for it. For example, if you pay $90 for a share of stock and sell it for $100, you have a $10 capital gain. If you hold the asset for over a year, you’ll pay long-term capital gains tax, which is assessed at lower rates than ordinary income tax. On the other hand, if you hold the asset for a year or less, it will be subject to short-term capital gains taxes, which is taxed at the same rates as ordinary income or at your marginal tax rate.
Depreciation recapture occurs when you’ve claimed depreciation expenses on a property in previous tax years. Depreciation is one of the best tax benefits of real estate investing for maximizing year-to-year income. But, upon the sale of a property, any depreciation you’ve claimed will be taxed as income. And depreciation is always taxed as ordinary income.
How much do I need to spend on a replacement property?
To complete a 1031 exchange and avoid taxes completely, you need to spend at least as much on a replacement property as you receive for the original property. If you sell a property for $1 million, you’ll need to spend at least $1 million on the replacement property to defer all taxes. You can spend more than this, but not less.
It’s also worth noting that acquisition costs count. If you buy a replacement property for $980,000, but also spend $20,000 on legal fees and various other acquisition costs, it's considered a $1 million investment.
I had a mortgage on the property I sold. How does this come into play?
The 1031 exchange rules say the purchase price of your replacement property needs to be equal to or greater than the sale price of the original and the amount of debt you carry must be equal to or greater than the amount of debt you had on the original property.
For example, if you sell a property for $1 million and had a $400,000 mortgage, you can buy a property for $2 million with a $1.2 million mortgage. You can’t sell a property for $1 million with a $400,000 mortgage and buy another property for $1 million with no mortgage.
One of the most common reasons for doing a 1031 exchange is to increase your leverage. For example, if you own a $1 million property free and clear, and use the proceeds from the sale to acquire a $3 million property with a $2 million loan, the 1031 exchange could help you do this and increase your income potential.
Can I do a partial 1031 exchange?
Yes, you can do a partial 1031 exchange. This is one of the more misunderstood parts of the 1031 exchange rules -- it's not an all-or-none situation. You can choose to reinvest part of your sale proceeds, not take on as much debt as you had in the original property, or a combination of the two. However, you’ll have to treat the portion of the sale proceeds you keep or the reduction of debt as income.
Put simply, you can choose to only reinvest a portion of the original property’s sale proceeds in a replacement property. This has the advantage of allowing you to pocket some of your investment gains while still deferring taxes on some and maximizing its reinvestment potential.
As a simplified example, let’s say you sell a property for $1 million and that the property had a $500,000 mortgage at the time of the sale. You then purchase a new property for $800,000, also with a $500,000 mortgage. Since you didn’t reinvest 20% of the sale proceeds, you would be responsible for a corresponding proportion of the taxes normally owed on the sale.
Can I sell a property I co-owned and do a 1031 exchange with just my portion?
Generally, the answer to this question is no. One of the rules of 1031 exchanges is that the original property’s owner and the replacement property’s owner must be the same. In other words, if your name is on the title of the sold property, your name should be on the replacement property. If the name of a partnership or LLC is on the title of the original property, the same name should appear on the replacement property.
For example, if you own a property through an LLC with three equal members, the LLC can’t sell the property and let you complete a 1031 exchange with your third of the proceeds. However, an LLC can complete a 1031 exchange on an entity level.
What is the 45-day identification window?
There are two deadlines you need to worry about when completing a 1031 exchange. The first occurs 45 days after the sale of the property.
The first 45 calendar days after closing on the sale of an investment property intended for a 1031 exchange is known as the "identification window." This is when you need to identify potential replacement properties to buy.
Specifically, you have 45 days to identify as many as three like-kind properties to buy. You can identify four or more properties if you choose, but their combined value cannot exceed 200% of the sale price of the original property. For example, if you sell a property for $1 million, you can identify as many replacement properties as you want as long as their combined value doesn’t exceed $2 million. Otherwise, you’re capped at three.
Properties must be identified in a signed, written document that must be delivered to a third-party intermediary. The replacement properties must be clearly described. Use the property’s street address or legal description. Not vague descriptions like "triplex on Main Street." If you sold more than one property as part of your 1031 exchange, the 45-day identification period begins on the date of the first closing.
When do I need to complete the 1031 exchange?
The second date you need to worry about occurs 180 days after the sale of the relinquished property. This is the date by which the 1031 exchange needs to be completed. This means that you’ve closed on the replacement property.
Specifically, you must receive the replacement property and complete the exchange by one of two dates:
- The 180th day after the date on which you transfer the original property.
- The due date (including extensions) for your tax return for the year in which the original property’s sale occurred.
You have to complete the exchange by the first of those two dates.
Can I do a 1031 exchange with a house I fixed and flipped?
Not really. While the IRS doesn’t have specific definitions when it comes to the holding period, there's a clear distinction between a property held for investment and a property you bought for the sole purpose of selling for a profit.
There’s some gray area here, though.
Let's say you buy a duplex, rent out both sides immediately, and make some improvements (like replacing the roof). Then you sell it at a profit a few months later. This could potentially qualify for a 1031 exchange. You can use the fact that you collected rent income to show that you held the property for investment reasons.
On the other hand, imagine that you buy an unoccupied property. You do substantial renovations and immediately put it on the market. It’s pretty clear to the IRS -- and anyone else who looks -- that your primary goal was to sell for a profit.
If you're considering a 1031 exchange, consult a tax professional to evaluate your situation.
Can I do a simultaneous or immediate 1031 exchange?
You certainly can. Just because you’re allowed 45 days to identify replacement properties and 180 days to complete a 1031 exchange doesn’t mean you need to use them.
If you find an acceptable investment opportunity and a buyer for your original property, you can buy and sell properties at the same time.
There are a few ways this can happen. Perhaps the least complicated is if you find another investor who is willing to trade properties with you. It’s acceptable for two property owners to swap deeds for the purposes of completing a 1031 exchange.
What if different parties are buying your original property and selling your replacement property? You can set up a simultaneous exchange between all three parties using a qualified intermediary or facilitator.
Can I buy a replacement property before selling my investment property?
The most common form of 1031 exchange is a delayed exchange. Most people sell an investment property, identify replacements, and close on a replacement property later. But it can work the other way as well.
In other words, you can set up a reverse 1031 exchange by purchasing an investment property before selling another property that you own. The timeline for this process is the exact opposite of a typical 1031 exchange. After buying the new property, you’ll have 45 days to identify which property is going to be sold and a total of 180 days to complete the sale.
What is a qualified intermediary?
A 1031 exchange qualified intermediary accommodates the completion of 1031 exchanges on behalf of investors. This can be a person or a business entity.
A qualified intermediary cannot be:
- your real estate agent at the time of the transaction,
- related to you, or
- related to your agent at the time of the transaction.
Anyone who meets one of these criteria is known as a disqualified person. In simple terms, a qualified intermediary must be a third party with no potential conflict of interest in the transaction.
Qualified intermediaries essentially facilitate the entire 1031 exchange. They acquire the original property from the owner and transfer it to the buyer. Then they acquire the replacement property from the seller and then transfer it to the borrower.
Do I need to use a facilitator or qualified intermediary?
Technically speaking, you don’t need to use a qualified intermediary to facilitate a 1031 exchange. According to the IRS, your exchange facilitator can be a qualified intermediary or a "transferee, escrow holder, trustee, or other person that holds exchange funds for you in a deferred exchange under the terms of an escrow agreement, trust agreement, or exchange agreement."
That doesn’t mean trying to complete a 1031 exchange without the services of a reputable and experienced intermediary is a good idea. After all, you could represent yourself in court. Most people choose not to because it’s generally not a smart move. The same idea applies here.
In short, ensuring that a 1031 exchange is done properly is complicated. A qualified intermediary can ensure that things happen in the proper order and that documentation is done correctly.
How long do I need to hold properties I use in a 1031 exchange?
There's no set minimum holding period for a property used in a 1031 exchange. The only requirement is that you owned the property with the intention to hold it as an investment.
There's a clear distinction between holding an asset as an investment and buying an asset for the specific purpose of making a profit on its sale.
If you held an investment property for a relatively short amount of time, the probability of an IRS audit is rather high. As long as you can substantiate your claim that you intended to hold the property for investment when you bought it, you don't have much to worry about. Just remember that things like fix-and-flip properties are not qualified.
1031 exchanges can be very complicated. But now you have the answers to some common questions and you should be prepared to evaluate whether you're eligible for one.
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