What is a 1031 Exchange in 2021?

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What is a 1031 exchange?

1031 exchange is the process of selling an existing investment property and using those proceeds to buy a new investment property of similar or more value in order to defer capital gains tax. The basic principle is that if you don’t receive the proceeds from the sale of the property, then there isn’t any profit to be taxed. The name 1031 exchange is a result of the US Internal Revenue Code ‘Section 1031’ which refers to deferring capital gains tax on an investment property.

1031 Exchange

1031 exchange essentially allows you to defer the capital gains tax when you sell the investment property and buy a new one within a certain time period and of similar value. Most investment property proceeds are taxable, however, if you meet the requirements and qualify for a 1031 exchange, you can defer the entire capital gains tax or at least a part of it. 1031 exchange can be used for investment, business, and vacation properties, but both the investments must be located in the United States.

Example

  1. Purchase price of existing property = $700,000
  2. Proceeds from the sale of existing property = $900,000
  1. Total Profit = $200,000 ($900,000 - $700,000)
  2. Capital Gains Tax Rate = 20%
  3. Total Capital Gain Tax Payable = $50,000 ($200,000 * 20%)
1031 Exchange can defer $50,000 which can be used for the next investment property

How does a 1031 exchange work?

In order to do a 1031 exchange, you will require a Qualified Intermediary. A qualified intermediary is a person or an organization that assists in the 1031 exchange. The qualified intermediary will receive the funds when you sell the existing investment property rather than you, the seller of the property. When the new investment property is determined and approved then the qualified intermediary directly transfers the funds to the seller of the new investment property. The qualified intermediary should not be formally linked to any of the parties involved.

How a 1031 Exchange Works

1031 exchange can take place as many times as you want and can grow your investment tax-deferred. You can continuously buy and sell new property without paying capital gains tax as the tax gets deferred every time you make use of the 1031 exchange. You can have a profit on each transaction, but you won’t have to pay the tax until you cash-out in the future. If everything goes to plan and you are ready to cash-out, you will only have to pay one tax on all the profit and if you are retired, you will only have to pay tax in the lowest-income bracket as a long-term capital gains tax.

1031 exchange rules

There are two major subsets of rules to be followed, the property must be a like-kind property and you must follow the timing rules.

Like-Kind Property

The new property that is purchased must be similar to the existing property in terms of characteristics and nature. For example, it is permissible to exchange vacant lands for commercial buildings or residential property for industrial property. However, you cannot sell the investment property and purchase designer jewelry or artwork as that is not like-kind. The property has to be used as an investment and not for personal use or resale, which means a minimum time to hold the property is at least 2 – 3 years. There are 3 different designation rules that can be used for identifying a new property:

  1. 3 Property Rule: You can find 3 properties as potential purchases irrespective of their market value.
  2. 200% Rule: You can identify numerous properties as potential purchases as long as their cumulative value is not greater than 200% of the existing property being sold.
  3. 95% Rule: You can identify numerous properties as potential purchases as long as you acquire the properties at 95% of their total value or more.

Timing Rules

These rules apply for the delayed 1031 exchange which is the most common type of 1031 exchange:

  1. 45-Day Rule: You must find a replacement property within 45 days of selling your existing property. You can designate and undesignate potential replacement properties at any time during this 45-day period. The new property details, such as the property’s legal description or address, have to be sent to the intermediary. You can follow the 3 designation rules above, as long as you close on the new property.
  2. 180-Day Rule: You have 180 days to close on the new investment property from the date when your existing property is sold.

What is a simultaneous 1031 exchange?

Delayed 1031 exchange is most commonly used when the existing investment property is first sold following which a new property is purchased within the time constraints as stated above. However, there is another form of exchange known as the simultaneous 1031 exchange As the name suggests, rather than selling the first one and then buying another, the transactions take place simultaneously.

If two investment owners want to swap their properties, they can undergo a simultaneous 1031 exchange to make it happen. The other way it can take place is that a third-party facilitator organizes a simultaneous exchange between various buyers and sellers of properties.

What is a reverse 1031 exchange?

A reverse 1031 exchange takes place when you find the investment or replacement property before you sell your existing investment property. The timing rules work the same way but in an opposite manner, you have 45 days to sell your existing property from the point you purchased the new property and 180 days to close and finalize the sale from the point you purchased the new property.

How much does a 1031 Exchange cost?

Every property purchase will have closing costs which can include lender fees, third-party fees, and taxes. Closing costs can range from 2% - 5% of the purchase price. Apart from closing costs, you will also have to pay for the 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. For example, if a firm holds $800,000 for 2 months at 3%, they can earn an additional $4,000 ($800,000*(3%/12)*2).

When should I use a 1031 exchange?

There are several reasons to consider using a 1031 exchange, some of them are as follows:

  1. You are changing up your investment portfolio and want to diversify or have found a better return opportunity
  2. If you own and manage the property, you might be looking to purchase a property that is professionally managed rather than doing it yourself
  3. Estate planning purposes where you wish to consolidate your properties into one asset
  4. To avoid depreciation recapture. This is a process where you will have to pay for the depreciation when the property is sold, and it is taxed as ordinary income. This can be avoided with a 1031 exchange.

These are all valid reasons to consider a 1031 exchange, however, the biggest benefit is still the ability to defer capital gains tax. For example, if your capital gains tax rate is 25% and you sell a property for a profit of $100,000, you can defer paying $25,000 in capital gains. This can allow you to use the capital and profits from the previous transaction to purchase the new property allowing you to grow your wealth.

1031 tax exchange

1031 exchange is a great way to defer capital gains tax when you sell an investment property and plan to purchase another investment property of similar kind and value. However, if the new property you purchase is less than the existing property that you sold, the difference known as the ‘boot’ is considered taxable. For example, if you sold a property for $850,000 and purchased a new investment property for $800,000, then $50,000 ($850,000 - $800,000) which is the boot is taxable. You will receive the boot or the additional funds 180 days after the existing property is sold and it will be considered as capital gains.

The next point to consider is the loan or mortgage you have on the existing property and the new property. Even if you do not receive cash in the form of capital gains, but your liabilities go down, that will be taxable too. For example, if you have a mortgage of $700,000 on the existing property and purchase a new property with a mortgage for $600,000, then the $100,000 ($700,000 - $600,000) drop in liabilities will be taxed as capital gains.