As a real estate investor, you likely have heard of a 1031 Exchange for like-kind property. Yet, you may not be aware of the details of when to implement a 1031 Exchange, why it can be beneficial, and why you need to know. Savvy investors use 1031 Exchanges to create generational wealth. Savings from the deferred taxes are used to scale a portfolio more quickly.
The term 1031 Exchange gets its name from the Internal Revenue Service (IRS) code Section 1031 that allows owners of investment property to defer federal taxes on certain exchanges of real estate.
While it may seem like a newer investment term, the first tax deferred exchange was authorized as far back as 1921 with the present-day version adopted in 1954. A 1031 Exchange is also known as a Starker Exchange, resulting from a legal action about a property exchange that T.J. Starker filed and won against the IRS in the late 1970’s.
Today, thousands of real estate investors utilize exchanges for the tax benefits. It’s always best to consult with a tax advisor and to fully understand the IRS requirements yourself before diving in.
How Does a 1031 Work?
Generally, a 1031 is used to swap—or exchange—one like-kind investment property for another without incurring capital gains, so it’s basically a tax-deferred investment. The replacement property must be of equal or greater value than the relinquished property.
To comply with IRS regulations, you must enter into an Exchange Agreement with a qualified intermediary, who handles the funds between the two transactions.
Because there’s no limit on the number of times you can do a 1031 or how frequently, you can roll over the gain again and again and avoid or limit your tax liability OR until you ultimately sell the property for cash. And then you pay just one long-term capital gains tax at the current rate. This is how generational wealth is passed forward with deferred taxes.
What Types of Properties are Allowed?
Remember, a 1031 exchange involves selling a property and reinvesting quickly in another like-kind property. It’s important to understand buyers or sellers of their own homes cannot utilize this tax advantage.
The term “like-kind” has limitations and guidelines that MUST be met, but to do the exchange, the new property doesn’t have to be a totally similar property to the one you sold.
The IRS allows exchanges of an apartment building for a strip mall, as an example. But there are rules and limitations–like vacation homes–so be sure to fully understand what you’re doing before you begin the exchange process.
What is the 45-Day Rule, and the 180-day Rule?
Within 45 days of the sale of your investment property, you must designate in writing a replacement property that you want to purchase. In addition, the IRS requires that you must close on the new property within 180 days of the sale of the first property. These timelines run concurrently, so if you identify your replacement property 45 days after the sale of the first property, you have just 135 days left to close on the new property.
If you cannot locate a new property within the rules, you will not be penalized by the IRS. The exchange simply fails, and you will be required to pay taxes on the gain.
There are many more details to know and understand when it comes to 1031 Exchanges. Conduct careful research and seek the opinion of a knowledgeable advisor before proceeding.