If you want to expand your investment portfolio through real estate, you should definitely pay attention to the 1031 exchange. The same knowledge could also come in handy if you are thinking about selling one of your properties and buying another for investment purposes.
The 1031 exchange is probably one of the least known forms of investment strategy that allow you to defer capital gains tax after selling and buying a like-kind investment property.
1031 exchanges can be one of the most lucrative ways of developing your real estate portfolio if done correctly. Here are the ten essential things you should know about 1031 exchanges.
Understanding Section 1031 Provision
A 1031 exchange is a barter or swap of one’s business or investments assets for another of like-kind. The US Internal Revenue Code section 1031 defines what type of trade will be recognized.
Although the exchange can be for various assets, its primary use is real estate investments. Most property exchanges are taxable as sales, but if yours qualifies for a 1031 exchange, you can have your capital gains tax deferred.
Thankfully, there’s no limit on the number of times an investor can capitalize on a 1031 exchange. In short, you can buy investment properties and swap them as many times as you wish, as long as they meet the requirements.
Finally, you can pay tax at the long-term capital gain rate when you sell for a profit. Here are the fundamental points you should familiarize yourself with 1031 exchanges:
1. Exchange Property Should be for Business or Held for Investment Purposes Only
This provision for exchange is only for trade, business, and investment properties and not for personal use. Properties used as primary residences or vacation homes do not qualify.
However, a former primary residence may be applicable under certain conditions.
2. Exchange Property Should be of Equal or Greater Value
It is important to note that the replacement property has to be of equal or greater value than the property you have sold. There is a provision to re-invest your proceeds into one or more properties of equal or more value.
Properties cannot qualify if they are in different countries. Both properties must be in the United States to be eligible for the 1031 provision.
3. Properties Must be ‘Like-Kind.’
The terminology ‘like-kind’ can cause some confusion as even though the like-kind phrase is broad, you should be careful how you use it.
Replacement properties should not necessarily be the same type, but similar; both assets should be income-generating or held for investments.
For example, you may swap land with a building, or a multi-family home with a commercial property, so long as they are suitable for exchange.
Video: The 1031 Exchange Explained | A Faster Way to Build Wealth
4. Only Specific Types of Properties Qualify for the Exchange
Changes to the tax bill applicable after January 2018 indicated that tax-deferred exchanges are now only valid for the buying and selling of real estate, referred to as real property.
All investment real estate property qualifies for an exchange, such as:
- Land
- Commercial properties
- Single-family homes
- Multi-family homes
Other assets such as vehicles, machinery, and other intangible business assets do not qualify for like-kind exchanges.
5. Properties Held for Sale do not Qualify
If you buy a property intending to sell, you will not qualify for this provision. That’s because properties held primarily for sale cannot apply this exchange provision. If you sell this type of property, the taxman will treat it as ordinary income and charge you accordingly.
If, however, you maintain the property for investment purposes for several years, and the property attracts market-based gains, then you could qualify for the 1031 provision.
6. There are Time Constraints When Choosing Replacement Property and Closing the Deal
There is a stipulated timeline for the exchange and two fundamental rules to be observed. You have 180 days to complete the transaction after the transfer of the exchanged property.
Basically, from the day you sell your property to the final closing of the replacement property, you would have six months to complete the transaction. You have 45 days from the sale date to identify one or more potential properties for exchange formally.
7. The Role of a Qualified Intermediary
Any proceeds that you receive from the sale of your property should be taxable. However, you should not touch the sale proceeds for the transaction to be eligible for the 1031 exchange. This is one critical factor that most investors are unaware of and often make mistakes.
It would be best if you transferred all sales proceeds to a third party, a qualified intermediary, who holds the proceeds and transfers them to the seller of the next property for you. Be careful not to use your own agent or fiduciary such as attorney, realtor, or Certified Public Accountant.
8. Three Property Identification Rules Apply
Identification rules will apply differently to multiple properties. In the first instance, you may identify up to three properties that are like-kind to be your replacement properties, irrespective of their value in the market.
The other rule allows you to identify an unlimited number of properties as long as their cumulative market value does not exceed 200% of the fair market value of your property.
The last possibility is known as the 95% rule, where you may identify several properties, but you must close on 95% of the value of all the properties you specified.
9. Consider Depreciation Recapture
Since depreciation allows for lower property tax throughout its useful life, YOU should target this and capture some of these deductions and consider them into the total taxable income.
10. File Your Reports to IRS
When filing your tax returns for the year, you also need to report the exchange. Use Form 8824 to indicate the exchange details, including the transfer dates, description of the properties, and their value.
If you assumed some liabilities after the transfer of properties, you should also indicate that correctly. Be careful when filling in the form to shield from adverse effects such as penalties or a high tax bill.
Final Word
The 1031 provision allows many investors to defer their capital gains tax until later. That means many investors can grow and diversify their portfolios in an easy legal way.
However, you must engage with a qualified intermediary who will walk you through all the transaction steps and take advantage of this option to grow your portfolio.
Prepare the exchange properties well in advance and arm yourself with the correct information as you only have six months to complete the transaction after the initial sale.
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