What is a 1031 Exchange?
By Valerie Brown
Have you heard of a 1031 Exchange? A transaction involving a 1031 Exchange is a way the tax code allows you to sell your investment property, buy a new investment property, and defer all of the capital gains taxes. Leveraging finance is what it is all about. In a nutshell a 1031 exchange work a little something like this:
- First, you call a 1031 Exchange “'qualified intermediary”, they start the exchange process for you.
- Work with your realtor to sell your old property
- At the closing, the money goes straight from the closing to your QI. (I explain why below)
- Work with a realtor to buy a new property.
- When you finally get ready to close on your new property, the QI sends your money to the closing.
Handling the sale of your investment in this way, you buy and sell real estate without handling any cash. Technically, in the eyes of the law, you are exchanging properties. If you possess, hold, realize or control the money at any time between the sale of your old property and the purchase of your new property, it becomes a taxable event to you.
However, when you do a 1031 Exchange, you sell your old property, the money bypasses you and goes straight from the closing to the QI. Later, the money goes straight from the QI to the closing of your new property. Legally, you never realized, received or controlled the money from the sale of your property and therefore will not be taxed.
Why not just buy and sell outright?
When you sell something, you receive payment, which means you become culpable in the IRS’s eyes as owing tax for the money received. At minimum fifteen percent of your hard earned cash goes to the federal government in the form of capital gains tax. Many states also have a capital gains tax of their own to impose.
Even if you reinvest the money right away and purchase something else immediately, the IRS still considers it a taxable event because you received the money. This is where 1031 Exchanges are vital for leveraging real estate properties. Your goal is to sell and buyer all estate without actually touching your money or profits so you don’t get taxed on it.
This sounds like tax evasion, is it?
No, it's not tax evasion at all; 1031 is an IRS code (no. IRC §1031) the IRS wrote the code specifically for the needs of those looking to leverage their money and reinvest it without being penalized.
Benefits of a 1031 Exchange:
- You keep more of your money. You could pay upwards of 30% capital gains tax, just to the federal government, this does not include any state imposed capital gains taxes. The 1031 Exchange can save you tons of money you would otherwise be required to turn over.
- You can leverage the extra money on the new (replacement) property and have more buying power. It may help you avoid the dreaded Alternative Minimum Tax (AMT). In short, its way of preserving your working capital as you build your real estate empire.
Here's an example: Let's say you have a rental house you have owned for several years. It's increased nicely in value and it's been a good investment, but what you'd really like is a beach house off the coast. If you just sold the rental house to buy the beach house without doing a 1031 exchange, your tax bill could be huge (25% for depreciation, 15% for federal capital gains, 0-11% for state capital gains, and then there's that dreaded AMT).
Now, same scenario but this time you did a 1031 exchange instead. All of those taxes you would have owed would be transferred (deferred) over to the beach house. All of the money you would have paid to the government is now available to buy a better beach house. Of course, there are some rules involved, maybe a little more than some rules, it is IRS CODE after all.
There are however six important things to remember and know about 1031 Exchanges and they are listed below.
Six Things to Know About 1031 Exchanges
#1 Real Property Use - Both your old and new property must qualify as investment or business use. If both properties pass this test, you can exchange nearly any type of real estate.
#2 45 Day Identification Period - You have 45 days from the closing of your sale to list the properties you may want to buy. There are no exceptions to the deadline.
#3 180 Day Exchange Period - From the sale closing date, you have 180 days to close on the purchase of one or more properties from the 45-day list. Again, there are no exceptions to this deadline.
#4 Qualified Intermediary (QI) - The IRS mandates that you use a QI to prepare the legal documents for your exchange. The QI also holds your money, so that you do not have access to it.
#5 Proper Title Holding - You must purchase and take title to your new property exactly as you held title to your old property.
#6 Reinvestment Requirement - To defer all of your capital gain tax, you must buy a property equal or higher in value than the one you sold. Also, you must reinvest all of the cash proceeds from your sale.
This article is intended for educational purposes. We recommend to consult with a tax professional to fully understand all tax implications and to consult with your attorney before making any binding legal decisions.