If you are considering selling an investment asset, and trying to figure out how to avoid taxes, you should familiarize yourself with the concept of a 1031 exchange. In this post we will provide some basics. It will quickly become clear that if you decide to pursue this strategy you should first connect with a tax accountant.
A 1031 Exchange refers to a section of the IRS Code which, not surprisingly, is section 1031. The strategy allows an investor to defer paying capital gains taxes on an investment property when it is sold. The deferment occurs by purchasing a “like-kind property” with the profit gained from the sale of the first property.
What Does Section 1031 Say?
The IRS Code 1031 provides that no gain or loss needs to be recognized on the exchange of property held for investment, if the property is exchanged solely for property of a “like kind”. Before 2018, a wide array of property was covered by the deferment provisions of Section 1031. The Tax Cuts and Jobs Act of 2017 repealed Section 1031 for all types of property except real property.
Dealers Are Not Considered Investors for 1031 Purposes
If you want to use a 1031 exchange, you want to avoid activities that could cause the IRS to classify you as a dealer instead of an investor. An investor holds property for a period of time (usually longer than a year) and a dealer develops property or purchases property with the intent to make improvements and sell. The difference between the two is one of the gray areas of Section 1031. It can be very difficult to identify whether the IRS may consider the property owner a dealer or investor. Again, discuss your specific activities with a tax accountant to determine if the 1031 exchange should be considered.
Not As Simple As It Sounds
With the exemptions available under Section 1031, an entire industry thrives. As a real estate investor, someday you will decide to sell. Understanding Section 1031, and how to utilize it to your advantage, could save you thousands of dollars in taxes.
So a 1031 exchange sounds great, right? Basically just swap a property for another property of like-kind. But think about it. What is the likelihood that the property you want is owned by someone who wants your property? Don’t give up on the 1031 exchange quite yet though. There are solutions to this problem also.
In 1979, Section 1031 capital gains exclusions were expanded by the courts. The ruling approved non-simultaneous sale and purchase of real estate in a 1031 exchange. This process is sometimes called a Starker exchange. The name comes from the investor family who challenged, and won, in the tax court on the concept of only simultaneous closings being eligible for a 1031 exchange.
What is a Starker Exchange?
Most 1031 Exchanges involve much more complexity than a simple exchange of like-kind assets. Enter the delayed (or Starker) exchange. Today, the majority of 1031 exchanges are delayed, Starker, exchanges.
In a Starker exchange, a middleman known as a qualified intermediary (QI) is selected to hold the cash from the sale of your property. This third-party intermediary will then use your cash to buy the replacement, like-kind, property on your behalf. This three party exchange is called a swap.
A QI must be used to facilitate the transaction. Their role is to hold all the profits from the original sale, and then disburse those monies at the closing of the new property. The QI is an independent 3rd party (not your attorney, agent, broker or CPA) who holds the sales proceeds and purchases the replacement property on your behalf. Look for reputable, insured and bonded qualified intermediaries.
If you buy real estate for $100,000 and then sell it for $500,000, you are subject to paying capital gains taxes on your $400,000 profit. From that $400,000, you might lose, for example, $120,000 to capital gains taxes. With a 1031 exchange, you can use the full $500,000 to purchase one or more new properties and pay no capital gains taxes at the time of sale. The sale’s proceeds fund new investment properties, which in turn may generate cash flow and appreciate.
While you will eventually have to pay taxes when you sell these new properties, you may be able to make your money go further using a 1031 exchange. These types of exchanges can help real estate investors create wealth. Investors may use 1031 exchanges to buy bigger or better properties and potentially reap the rewards.
Opportunity to move funds into a different type of real estate asset.
Perhaps you are investing in properties that are high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. The opportunity to use this method of exchange can assist an investor to transition to a different real estate asset class.
Challenges of Using A 1031 Exchange
The investor (or exchanger) must follow the strict 45 /180 day guidelines for an exchange. Once the exchanger sells their property (relinquished property) they have 45 days to identify a property of equal or greater value. Upon identification, the exchanger has 180 days from the day they sold their property to acquire the property(s) identified (or 135 days from the end of the 45-day period).
Finding Like-Kind Property
The investor must acquire “like-kind” property. This means that the new property must be other qualifying forms of real estate. For example, the exchanger could sell a duplex and purchase a commercial property. Or they could sell a piece of land and buy an apartment building. The property just needs to be “like-kind.”
The property sold (relinquished property) and the newly acquired property (replacement property) must be held for investment or business purposes. You cannot sell your primary residence and buy an investment property or vice-versa. The like-kind property should be of the same nature or character, even if they differ in grade or quality.
The IRS guidance on like-kind properties is:
“Both properties must be similar enough to qualify as ‘like-kind.’ Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
If the exchanger sells a property for $1 million, in which $500k was equity and $500k was debt, then the exchanger needs to purchase $1 million or more worth of property. Furthermore, the exchanger needs to use all the equity and replace all of the debt to defer 100% of the capital gains taxes.
The exchanger may add additional proceeds to the new purchase if he/she wishes. They can also take on additional debt if desired. If the exchanger does not wish to use all of the sales proceeds he/she may do a partial exchange and pay the applicable capital gains taxes on the difference.
Cash to equalize a transaction cannot be deferred under Code Section 1031 because cash is not of like kind. This cash is called “boot”. The gain, to the extent of the receipt of cash, will be taxed at a normal capital gains rate.
Get Started By Consulting With Professionals
The purpose of this post is to provide a simple introduction to the concept of a 1031 exchange. As you have learned, this is not a transaction that can be done without professional assistance. If you are preparing to sell, this method of sale could help preserve capital gains by deferring taxation. Schedule an appointment with a tax accountant and learn specifically how you might use this tool.