The Basics of a 1031 Exchange
9 Things You Should Know
Property investors want to make money on their investments. When you go to sell your property, you will have to pay taxes on any gains you have made. That is, unless you do a 1031 exchange. Here are nine basics you should know.
What Is a 1031 Exchange?
A 1031 exchange is a way to sell a property without having to immediately pay taxes. The idea is that you will roll over any gains into the purchase of a new property, which allows you to defer paying taxes until you sell the new property, unless you do another 1031 exchange.
What Criteria Do You Have to Meet?
To qualify for a 1031 exchange, you must purchase another investment property that is of equal or greater value than your current property. You must use any gains from the previous property sale to purchase the new property. The new property must be considered a “like-kind” investment.
What Is Like-Kind?
Like-kind is a broad term, but it simply means replacing one type of investment with a similar type of investment. For property investors, it does not have to be the exact same type of property, it just has to be an investment property. For example, if you sell a multi-family property, you can buy any other type of real estate that is considered an investment, such as another multi-family, a retail property, a condo or a plot of land.
Who Can Do a 1031 Exchange?
A 1031 exchange can be done with property that is used for investment or for business. It cannot be done with personal residences.
Why Would You Do a 1031 Exchange?
The main reason to do a 1031 exchange is to defer paying taxes on any capital gains from selling a property. This allows you to immediately unload property you no longer want and purchase something new with the full amount of your gains instead of having to pay taxes on the gains first and then using whatever is left to buy property. It gives you more purchasing power.
Who Holds the Money Until Purchase?
As part of the 1031 exchange, you cannot personally hold onto any money you made from the sale of the first property. According to the IRS, this money must be held by a qualified intermediary until it is used to purchase the replacement property.
An example of a qualified intermediary would be a title agent, who is involved in assigning and transferring title from the old property and assigning and transferring title for the new property. To understand the complete definition of who the IRS considers a qualified intermediary, please see § 1.1031(k)-1(g)(4) of the treasury regulations.
How Long Do You Have to Do a 1031 Exchange?
One downfall of doing a 1031 exchange is that you do not have long to identify and close on replacement property.
- 45 Days
During a 1031 exchange, you have a 45 day identification period. Within 45 days of selling your current property, you must identify the property or properties you wish to purchase during the exchange.
- 180 Days
You have 180 days from the sale of your current property to close on the replacement property or properties.
Rules for Identifying Replacement Property
- Put It in Writing
In order for a property to be considered as a replacement property, you must identify the property, or properties, in writing by the end of the 45th day. You must include a physical description of the property, a legal description of the property and the property address.
You must sign this document. It is usually delivered to the same person, the qualified intermediary, who is holding the gains from the first property. It could also be delivered to the seller of the replacement property, an escrow agent or another person who is involved in the exchange.
- How Many?
There are two options when it comes to identifying replacement property.
1. Three Property Rule- You can identify a maximum of three potential replacement properties. In this case, it does not matter what the fair market value of the properties are.
2.Two Hundred Percent Rule- In this approach, there is not a maximum number of properties that you can identify. Instead, the total fair market value of the properties that you identify cannot be more than 200 percent of the fair market value of the properties that you sold at the time of the sale.
How Many Times Can You Do a 1031 Exchange?
The IRS does not set any limit on the number of 1031 exchanges an individual can do. As long as you are selling a property and then reinvesting the profit from that property into another similar investment, you can do a 1031 exchange and put off any tax consequences.
However, if you are doing a large number of 1031 exchanges, you could become classified as a dealer and your properties would be looked at more like stocks that are being traded. In this case, you would have to prove that you are using these properties as investments in order to continue doing 1031 exchanges.