What are 1031 Exchange Rules?
What You Should Know
- 1031 Exchange allows a homeowner to swap an investment property for another property of similar value and to defer the capital gains tax.
- 1031 Exchange refers to IRC Section 1031, which has a lot of detailed information about the procedure and timeframe for this kind of exchange.
- During the 1031 Exchange, the proceeds from selling the property must stay in an escrow account while the other property is not purchased.
- Exchanged properties must be considered similar in the eyes of the IRS to be eligible for tax deferral.
1031 exchange is a technique that allows a homeowner to swap their investment property for a similar property of a similar value to defer capital gains tax. This technique is possible due to the 1031 Section of the Internal Revenue Code (IRC), which provides detailed information on how a homeowner can defer capital gains tax by swapping one property for another. It is important to note that a 1031 exchange does not allow a homeowner to avoid paying capital gains but only allows them to defer the tax. This means that if a homeowner sells the swapped property in the future, they will have to pay capital gains tax that is calculated based on the price of the original property.
Section 1031 of the IRC outlines the conditions under which a swap would be free of tax or would have only a partial tax due at the time of the closing. The requirements outline what kind of property can be admissible for the tax break as well as the time a homeowner has to sell their property and buy a new one. A property owner who chooses to do a 1031 exchange should have a good understanding of the rules Section 1031 of the IRC outlines to get the most benefit from a 1031 exchange. It is important to note that Section 1031 only allows the deferral of capital gains tax. The investor will still have to cover transfer tax during the exchange.
- Relinquished Property - The property that an investor exchanges for another property during the 1031 exchange.
- Replacement Property - The property that an investor received during the 1031 exchange.
The most important rules of the 1031 section of the IRC are related to the type of real estate an investor can get in exchange for their investment property and how long the investor has to complete the swap. An investor can only swap their investment property for real estate of “like-kind”. The definition of “like-kind” in this case is very broad, so it allows the investor to swap their investment property for another investment property, undeveloped land, or industrial property as long as it is used as an investment. This means that the buyer has a lot of choices regarding what type of real estate they would like to get in exchange for their current investment. On the other hand, the investor should be quick with closing on the real estate they want to buy after closing on the property because section 1031 of the IRC allows the investor to identify and close on new property only 180 days after the sale of the investor’s property.
How Does a 1031 Exchange Work?
A 1031 exchange involves a sale and a purchase of a property, but it is done differently than a regular sale and a purchase of a property. During a 1031 exchange, the investor never sees the money from the sale of their property. Instead, a qualified intermediary is present during the exchange, and their role is to facilitate the exchange and hold the money in an escrow account after the sale of one property and before the purchase of another investment property.
Once an investor finds a qualified intermediary who is willing to facilitate the exchange, the investor can start looking for sellers as well as looking into properties that they would want to get as a replacement for the relinquished properties. Usually, a qualified intermediary has enough experience to guide the investor through the exchange process, which mainly differs from a regular sale and purchase only in the fact that the investor does not get to see the money from the sale of the property.
Once the property is sold, the proceeds are deposited into an escrow account that is overlooked by the qualified intermediary. Once the investor closes on the property they want to purchase, the intermediary releases the funds from the escrow account to the seller of the property. It is important to note that there are some time limits associated with the 1031 exchange. More specifically, an investor has to close on another property within 180 days after the sale of their investment property. This means that the investor may not be eligible for the tax break if the investor did not purchase an eligible real estate within 180 days after the sale of their investment property.
1031 Exchange Rules
There are certain requirements that apply to the properties an investor is trying to buy and sell as well as the timing of the exchange. Even though a qualified intermediary should be able to guide an investor through the rules of the exchange, an investor may benefit from understanding the rules beforehand because it allows them to prepare for the exchange and find the most desired properties.
Section 1031 of the IRC briefly describes the type of properties that can be used as relinquished and replacement properties in the exchange.
- “Like-Kind” Property Requirements
The property exchanged must be “like-kind” that is held for productive use in a trade or business or investment.
The term “like-kind” is not as strict as some people may think because the investor can purchase another investment property or any other real estate that is used for productive use. This means that an investor can buy land, houses, industrial plants, and other investment real estate regardless of what kind of investment property is being exchanged.
- Investment Property Restrictions
Section 1031 does not apply to any real estate held primarily for sale.
This is an important part of the section because it prohibits some properties that may be considered an investment by some, from being exchanged under section 1031. This means that if an investor purchases a property and keeps it vacant while the price of the property is appreciating, the investor may not be allowed to receive the tax breaks under section 1031 of IRC.
- Gains & Losses Not Solely in Kind
Any gains and losses that happen during the 1031 exchange as a result of the transfer of ineligible assets under the Section 1031 of IRC must not receive the tax breaks under Section 1031 of IRC.
Sometimes there are other assets that may be involved in the real estate transaction, and section 1031 allows for it to happen, but the investor may have to recognize capital gains on the ineligible assets they receive. A popular example of the time when an investor has to receive ineligible assets is when an investor purchases a property that is cheaper than the property they sell. The intermediary will release the difference to the investor, but the released sum will not receive tax breaks.
- Property Cost Basis
After the 1031 exchange, the replacement property will have the same cost basis as relinquished property adjusted for gains and losses not solely in kind.
A 1031 exchange is a useful technique to defer the capital gains tax, but it does not allow the to bypass it completely. If an investor has unrealized capital gains on their property, the capital gains will transfer to the replacement property after the original property is relinquished. For example, an investor bought a house for $100,000 and it rose in value to $500,000, so they decided to do a 1031 exchange. They found a property for $500,000 that they want to buy. Even though the replacement property is worth $500,000, the cost basis for tax purposes will be set at $100,000 once the 1031 exchange occurs.
There are a few time-related rules an investor must be aware of before engaging in a 1031 exchange. An investor may be ineligible for the tax break that comes with the exchange if the investor does not complete the exchange within the set timeframe. Understanding the rules related to the timing of the transaction may help an investor understand how they can prepare beforehand to complete the exchange in time.
- 45-Day Rule - Property Identification
An investor must identify the replacement property no more than 45 days after the original property is relinquished.
This rule states that an investor has to find a replacement property they want to purchase within 45 days after they sell their investment property. Once the investor identifies a property they want to buy, they have to notify a qualified intermediary about the property. An investor may identify up to 3 properties at once, and they may identify more properties to buy if they are planning to purchase multiple properties for the proceedings.
- 180-Day Rule - Exchange Completion
An investor must complete the exchange of the property no more than 180 days after relinquishing the original property.
This rule limits the amount of time an investor may have to close on a property to receive the tax breaks. The investor has in total of 180 days to close on the property, but it is also important to remember that the investor has only 45 days to identify the property they want to buy. Because of these time limits, an investor may benefit from preparing early and identifying the properties they want to buy beforehand.
Types Of 1031 Exchanges
There are different ways to exchange the property using section 1031 of the IRC. Even though a delayed exchange is the most common and well-known method of 1031 exchange, it is not the only one to consider. There are three distinct types of 1031 exchanges that may have different requirements and time limits.
A delayed exchange is the most common 1031 exchange strategy, and many people think of this strategy when they think of 1031 exchange. It allows a person to delay the swap of the property by 180 days, which allows the investor to find and close on an appropriate property. Once the relinquished property is sold, the proceeds go to a qualified intermediary who holds the funds in escrow until they are ready to be sent to the seller of a replacement property.
Reverse exchange is somewhat the opposite strategy to delayed exchange because an investor purchases the replacement property before relinquishing their original property. This strategy might be useful in competitive seller’s markets where buyers have a hard time closing on a property. Given the strict time limits associated with the 1031 exchange, an investor may choose to buy a replacement property beforehand to make sure that they can be eligible for the 1031 exchange.
It is important to note that the reverse exchange still requires a qualified intermediary to facilitate the transaction. If the investor does not get a qualified intermediary or conduct a deal directly, they may not be eligible to get a tax break under Section 1031.
This type of exchange builds on top of the delayed exchange strategy. This type of exchange allows the investor to get a property under the same conditions as delayed exchange, and it also allows them to renovate, repair or rebuild some parts of the property using the deferred tax money. The time constraints applied to delayed exchange are still effective for this exchange, so the investor has 180 days not only to close on a property but also to complete all relevant projects.
Tax Implications of 1031 Exchange
Not every transaction runs smoothly, and there may be some complications that may affect how much tax break on capital gains an investor receives. These complications may be caused by the difference in price between the relinquished and replacement properties, outstanding debt on the relinquished property as well as some cases of depreciable properties. Investors should identify what cases apply to them to make sure that they get the most benefit from the exchange.
Leftover Cash Implications
It often happens that there is some leftover cash sitting in an escrow account after the exchange is complete. If the qualified intermediary still has any money in the escrow account after the exchange is complete, the intermediary will send it to the investor at the end of 180 days after the sale of the original property. The leftover cash that is sitting in an escrow account is called boot and is taxed as partial sales proceeds from the sale of a property or as capital gains.
Many properties are financed with some kind of loan product, and the outstanding debt on the property must be considered when buying a house. Some people may not account for debt when doing a 1031 exchange. During the exchange, one loan gets covered while another is being originated, so it is important to keep track of the balance and the change in liabilities. If all cash is spent on a property, but the investor’s liability goes down, the difference in liabilities will be treated as leftover cash and will be taxed accordingly.
When depreciable property is exchanged, special rules apply to this exchange. Since the cost basis stays at the point of the original purchase price of an original property, if the property was depreciated, the 1031 exchange may trigger a depreciation recapture. If the recapture is triggered, the investor may have to pay ordinary income tax on the depreciation recaptured.
Real Estate Strategies With Section 1031
1031 exchange is used by many investors and homeowners to postpone paying tax for capital gains. There are a few strategies that are built around Section 1031 of IRC that help convert residential properties into investment properties as well as swapped properties into residential. Section 1031 can also be combined with other tax breaks available to minimize the taxes that need to be paid.
Residential Into Investment With 1031
Some people may want to swap their property for another property, but they use their property as a primary residence. Residential properties cannot be swapped because they are not considered to be investment properties. It is possible to bypass this restriction by renting out the residential property for a sufficient time for it to be considered an investment property. If the property consistently generates income for a year, it can be considered an investment property, and it can be swapped as a result.
This is a popular strategy for second homes and vacation homes that have risen in value. A homeowner of a second property could turn it into a rental property for about a year and swap it for another investment property once their second home is recognized as an investment property.
Moving Into a 1031 Swap Property
There is also a reverse strategy when a property is already swapped, and the investor wants to use it as a residential property. One of the requirements of the 1031 exchange is that the replacement property is used as an investment property, so an investor cannot simply move in there. Instead, the investor has to use it as an investment property for about a year, and after that time, it can be used as a residential property.
This is a continuation of the previous strategy that allows a homeowner to swap their second home for another investment property that can be turned into a residential property later on. Even though this strategy takes time, it can defer thousands of dollars in capital gains.
Estate Planning With 1031
Section 1031 of IRC allows capital gains tax deferral on an investment property swap, but the investor may still have to pay the capital gains tax once they sell the replacement property. Tax liabilities of an individual end with death and are not passed onto the family. If an investor does not need to liquidate their property, they may do 1031 exchanges indefinitely and pass the last property to their family. Once their family inherits the properties, the cost basis will be updated to the most recent one, and the capital gains tax would be forgiven. This strategy allows a homeowner to avoid capital gains tax, but they will not be able to benefit from the tax break directly, and their heirs may still pay inheritance tax in some cases.
Frequently Asked Questions
Who Is A Qualified Intermediary?
A qualified intermediary can be a person or a company that acts on your behalf during the real estate transaction. One of the requirements of the 1031 exchange is that an investor must have a qualified intermediary facilitating the transaction because the investor cannot receive the money directly from the sale of the property to receive tax breaks. Facilitating the exchange means that the qualified intermediary has to receive the payment for the relinquished property, keep the money in an escrow account, and release the money to the seller of a replacement property. There are other responsibilities a qualified individual has during the exchange. The following list provides a detailed list of responsibilities of a qualified individual during the 1031 exchange:
- Establishes communication between an investor and other parties involved in the transaction.
- Gets all paperwork related to the relinquished and replacement properties done.
- Provides necessary documentation to the escrow and title company about the 1031 exchange.
- Facilitates the transaction between the investors and other parties during the swap without the investor being involved in the process.
- Archives all information related to the exchange including the potential replacement properties.
- Prepares the documents to transfer the title for the property from the investor to the buyer and from the seller to the investor.
- Complies tax forms and issues to involved parties upon request.
When Should I Use A 1031 Exchange?
A 1031 exchange allows an investor to defer capital gains if an investor buys another similar property within a set period of time. Generally, there are different reasons why you would want to exchange property, but the main reason to do a 1031 exchange is to avoid capital gains tax. A 1031 exchange should be used only when there are unrealized capital gains on the property. You may want to exchange your investment property for the following reasons:
- To Get a Higher Return.
- To Bring All Properties You Own Closer Together.
- To Benefit From a Better Rental Market.
- To Diversify a Real Estate Portfolio by Selling One Large Property and Buying Many Small Properties.
How Do I Notify IRS About a 1031 Exchange?
Once the 1031 exchange has been completed, you are required to notify the IRS regarding this transaction by submitting Form 8824 along with the tax return for the year the exchange happened. You will have to provide details regarding the properties exchanged as well as the dates when the replacement property was identified and purchased. It also requires you to provide any relationship you have with the other parties involved in the transaction. It is a good idea to contact your qualified intermediary to help you compile the form. They may do it on their own and send the complete form to you, or they may help you by guiding you through the process.
Can I Do a 1031 Exchange on My Home?
1031 exchange is not intended for residential purposes, but there are strategies that allow a homeowner to swap their property for another. A homeowner may move out of their home, and turn it into a rental property until it is considered an investment property. Once it is considered an investment property, a homeowner may swap their property with a 1031 exchange.
Can I Do a 1031 Exchange on a Second Home?
Similar to the primary residences, secondary homes are also considered residential properties and are not eligible for 1031 exchange. On the other hand, it can be turned into an investment property and swapped then. To turn a second home into an investment property, the homeowner will have to rent it out for some time until it is considered an investment property.
How Much Does a 1031 Exchange Cost?
Even though the 1031 exchange allows you to defer some costs to the future, there are still significant costs an investor must consider before doing a 1031 exchange. Every property purchase and sale will have closing costs which can include lender fees, third-party fees, and taxes. During the exchange, you will have to pay the seller’s closing costs first. Once the replacement property is identified, you will also have to pay the buyer’s closing costs. Apart from closing costs, you will also have to pay for a qualified intermediary.
Qualified intermediaries are paid in two different ways, a fee and interest income. The fees can range from $600 to $1,200 for a standard delayed 1031 exchange, however, if there is more than one property involved or it is a complicated (simultaneous or reverse) deal, the fee is likely to increase. The second way in which the intermediary makes money is through the interest income earned from keeping your money in escrow. You do not directly pay interest to the intermediary. The money is kept in an escrow account from the point when your existing investment property is sold and the new one is purchased.