If you’re invested in real estate—and interested in remaining so—then a 1031 exchange is a tax tool that you can use to your advantage. In reference to a section of the IRS tax code, a 1031 exchange allows investors to reinvest the earnings from a real estate transaction into another piece of investment property, without paying capital gains taxes. However, there are some important rules to be aware of and pitfalls to avoid. Take the time to understand how these exchanges work, the eligible properties, and the critical timelines, and you may save thousands, or more aptly, tens of thousands of dollars.
What is a 1031 Exchange?
Investing in commercial property can be a lucrative endeavor, but capital gains taxes can take a big chunk of your earnings. A 1031 exchange helps solve this by allowing investors to defer paying capital gains if they invest their earnings into another property. You can’t use the exchange for personal property, but you can purchase another income-earning property that is akin—or “like-kind” in tax-speak—to the one you sold. You can make these exchanges as many times as you’d like. Then even if you profit off of each transaction, you’ll only pay one tax once you decide to cash out.
What Types of Properties are Eligible for a 1031 Exchange?
As noted, only investment properties are eligible. So you can’t use this exemption to swap personal property, such as a home. What’s equally as important is that you must exchange what the IRS refers to as “like-kind” properties. The definition here is broader than many people assume—it means that the property must have a productive use for business or investment. For investors, that opens up many opportunities. For example, you could exchange undeveloped commercial property for a residential apartment building or a commercial office building for a working ranch.
How Do 1031 Exchanges Work?
In the most basic use of a 1031 exchange, an investor would swap one investment property for another in a one-for-one exchange. However, the likelihood of finding another property owner with a parcel precisely like what you want—and who also wants your property—is not all that high. Instead, most investors do a three-party exchange, in which a middle party holds onto the money from the sale of the first property until the investor uses it to purchase the second property. In these scenarios, timing is of the essence. That’s because under the IRS code, an investor must designate a replacement property within 45 days. You can identify up to three properties in that period and then ultimately select just one.
What's the Deadline for the Transaction?
Beyond the 45-day rule, investors must also work quickly to reinvest their funds into a property once they’ve identified a proper replacement. The IRS allows 180-days to complete the purchase of a new property, starting from when the sale of the previous one closed. If you miss this deadline, then the 1031 aspect of the exchange is no longer applied. There is no way to request an extension, so it’s imperative that investors understand the deadlines and keep their purchase process on track.
Are There Other Ways to Void the Transaction?
While identifying the replacement property and completing the exchange with the designated periods need to remain top of mind, there are other pitfalls. For example, in an exchange the investor cannot take ownership of the property sale funds—even for a moment. Instead, investors make use of a qualified intermediary to hold the funds for them. The intermediary can’t be anyone that is an agent of the investor; so no one who has performed a financial service such as an accountant or attorney. Instead, most investors make use of companies set up specifically to act as qualified intermediaries. This creates the arm’s length transaction required by the IRS.
What if There’s Money Left After the Second Sale?
Finding two properties to sell and purchase for the same amount is no small feat. If there’s money left after you close on the replacement property, then you’ll get that cash back from the intermediary. However, you will have to pay capital gains on the remaining funds. In addition, if the amount of debt you hold decreases between the two transactions, you’ll also owe taxes on the difference. So if you had a mortgage on one property for $500,000 and the debt on your new property is $250,000, then you’re liable for taxes on the remaining $250,000, which the IRS will treat like income. To avoid this situation, aim to reinvest in a property that is of equal or greater value than the one that you sold.
Real estate is an excellent way to diversify your investment portfolio. Take advantage of 1031 exchange to defer capital gains taxes, and make the most of your investment dollars.