1031 Exchange: The Tool for Managing Taxes in Real Estate Investing
Investing in real estate is a popular and interesting way to build wealth. If you have an interest in this, it is important to understand the tax implications of buying and selling investment properties and how those can be managed through a 1031 Exchange.
A 1031 Exchange refers to a transaction in which you sell one investment property to purchase another. Typically, this type of transaction would trigger capital gains taxes. Yet, the IRS section 1031 allows you to defer those capital gains indefinitely. Sound too good to be true? It’s not.
But (you knew there would be a “but”) – there are several requirements to meet and the timing of each real estate transaction is critical.
The main requirements for a 1031 Exchange include:
1. You must purchase another “like-kind” investment property and it must have equal or greater value.
2. All of the proceeds from the sale must be invested in replacement property.
3. Title holder and taxpayer must be the same for both properties.
4. You must identify new property within 45 days and must purchase new property within 180 days.
Let’s explore a few of these terms, definitions and tips for executing a 1031 exchange:
What is a “like-kind” property in a 1031 exchange?
This is a broad term. According to the IRS, “properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.” Most real estate transactions will qualify as like-kind, as long as both properties are in the U.S.
What defines an “investment property” in a 1031 exchange?
In order to qualify for a 1031 exchange, the properties involved must be business or investment properties. Your primary residence does not qualify. However, you can exchange a single-family rental property for a multi-family rental or apartment building.
How are funds handled in a 1031 exchange?
It’s essential to understand the flow of funds to properly execute a 1031 exchange. In 1031, investors do not directly receive the proceeds from the sale of a property. Instead, those funds are held in escrow until the purchase of a replacement property. This transaction is typically facilitated by a 1031 exchange intermediary, also known as a Qualified Intermediary (QI).
Who should assist you with a 1031 exchange?
To do a 1031 exchange properly requires the help of a few professionals ensuring that you are following all of the timelines and guidelines. Beyond your realtor, be sure and involve your financial planning professional and accountant. Not only can they ensure you are taking all of the appropriate steps in the correct sequence, but they can also help you select a trustworthy qualified intermediary (QI), who will facilitate the exchange of funds throughout the transaction.
Why is timing important for a 1031 exchange?
Timing is crucial because of the IRS rules for 1031 exchanges.
First, the IRS requires that you identify potential replacement properties within 45 days of the sale of your property. For this reason, most investors will start identifying potential properties well before they sell their current investment.
Secondly, the IRS requires that the purchase and closing of a replacement property must occur within 180 days from the time the current property was sold. Note that the IRS is very strict with the 180-day window and counts every single day including weekends and holidays.
The Bottom Line:
Successful real estate investors use the 1031 exchange as a tax-deferred strategy to build wealth. The 1031 exchange is enormously beneficial, but also complex and time sensitive. Doing it properly requires you to understand the rules and obtain professional help.
If you are interested in doing a 1031 exchange or learning more about the process, contact one of PFGI’s experts by calling 610-422-3530.