As a property investor, expanding your portfolio is often a key to building wealth. When it is time to sell an appreciated piece of property, a 1031 exchange may allow you to defer your capital gains taxes so you can reinvest your entire sales proceeds into one or more replacement properties.
While a 1031 exchange can be a bit of a complex process, the results are often well worth the effort. This guide explains the basics of a 1031 exchange, including the critical rules that must be followed to avoid potentially having the exchange disqualified and losing your tax deferral benefits.
What is a 1031 Exchange?
The term “1031 exchange” comes from Section 1031 of the US Internal Revenue Code. It has been used by property investors since it was first passed into law as part of the Revenue Act of 1921 and remains a useful tool today. When done correctly, a 1031 exchange allows investors to defer capital gains taxes and depreciation recapture on real property exchanges.
1031 Exchange Rules
To qualify for a 1031 exchange, you must carefully follow IRS guidelines. To begin with, you must exchange your relinquished property for a “like-kind” replacement property. However, it is important to note that “like-kind” refers to the “nature or character” of a property, rather than the “grade or quality.”
In other words, nearly every type of investment property is considered like-kind to every other investment property. For example, you could exchange an apartment complex for farmland, a retail store for a condo, or a piece of vacant land for a medical building. No matter what type of property you exchange, to receive the full tax deferral, the replacement property must also be worth as much as or more than the relinquished property.
When engaging in a 1031 exchange, the property owner must not take possession of the proceeds from the sale of the relinquished property. Instead, the transaction requires the use of a third party, known as a Qualified Intermediary (QI). The QI holds the funds from the property sale and upon direction of the taxpayer uses it to purchase the replacement property on behalf of the investor and transfers the title to the investor to complete the exchange.
The 45-day rule and the 180-day rule provide important timelines for the completion of a 1031 exchange. The 45-day rule states that you must identify one or more replacement properties within 45 calendar days of the sale of your relinquished property. This identification must be done in writing and be delivered to your QI prior to midnight on the 45th day.
You also have 180 calendar days from the date of the sale of your relinquished property to close on one or more of the properties you identified. Keep in mind that these timelines run concurrently. If you take the full 45 days to identify the replacement property, you will only have an additional 135 days to complete your closing. The timelines also include weekends and holidays.
Since the IRS rarely provides extensions or exceptions and when they do so it is in relation to a catastrophic event such as a natural disaster, it’s critical to plan ahead. It’s also a good idea to identify a backup property, such as a Delaware Statutory Trust (DST), in case something happens that delays the closing on your first-choice property.
You’ll need to report your 1031 exchange by filing IRS Form 8824 with your tax return. This must be done at the end of the 180-day period or when your taxes are due, whichever comes first. If your tax return is due before you’ve completed your final transaction, you’ll need to file an extension.
A 1031 exchange may only be used for investment properties or properties that are used for business or trade. This means that you generally cannot do a 1031 exchange with your primary residence, a vacation home, or any other property that is primarily for personal use. 1031 exchanges are also limited to real estate investments, so you may not exchange securities, bonds, partnership interests, or any similar items.
Players in a 1031 Exchange
There are three primary parties involved in a 1031 exchange transaction: the property buyer, the property seller, and the qualified intermediary, who is sometimes also referred to as an exchange facilitator. According to IRS rules, the QI cannot be related to you or be your attorney, accountant, realtor, banker, or employee. It must be a disinterested third party, whose only role in your exchange is to receive the proceeds at sale, coordinate documentation for acquisition and disperse the monies come purchase time.
Since a 1031 exchange can be complex and mistakes are often costly, it’s helpful to work with a team of professionals who are well-versed in the process. While putting together your team, you may want to consult with a tax advisor, an attorney, an experienced real estate agent or broker who understands the intricacies of working with investment properties, and a company who focuses on this process and can help guide you through it all.
If you’re considering a 1031 exchange, the team at Fortitude Investment Group is here to guide you through every step of the process. You can get started by contacting our team to schedule a no-cost consultation.
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