The real estate market is hot right now. There are many reasons to consider getting into real estate as an investor. There are also big incentives to sell while the market is hot.
If you have real estate investments and are considering selling, what tax implications will you acquire because of the sale? Will you reinvest? Are you ready to move on from real estate and need to understand what selling the property can mean for you?
It might be time to learn about the 1031 exchange and how it could impact your real estate buying and selling.
Whether you have property or are considering getting into the commercial real estate market as an investor, it’s important to understand the real estate property exchange rules and implications for you. Read on to learn more about everything related to a 1031 exchange.
Table of Contents
What Is a 1031 Exchange?
A 1031 exchange comes from Section 1031 of the U.S. Internal Revenue Code. It is a way for those investing in real estate to sell one property and buy another property to avoid paying capital gains taxes.
When you sell a property and have a property, it’s almost always taxable. But if you carefully follow the intricate rules connected to a 1031 exchange, you can delay and avoid paying taxes on that gain.
When you participate in a 1031 exchange, it allows you to continue to grow your real estate investment and defer the taxes on the growth.
1031 exchanges are mostly considered for business and commercial property. However, you can use it to apply to a former primary residence. You can even use it to exchange vacation properties if you follow the rules strictly.
There are a myriad of rules connected to this IRS statute, and it’s important to consult a tax expert if you’re considering a 1031 exchange. These exchanges are also called like-kind exchanges or a Starker.
Why Is a 1031 Exchange Important?
For real estate investors looking to grow their wealth, the 1031 exchange can be very important. It allows them the opportunity to defer paying capital gains. Then to use the wealth to reinvest and work to build wealth over time.
At some point, when the properties are finally sold, the investor will have to pay taxes. Yet, the 1031 exchange allows them the opportunity to use the growth and stretch into bigger and better properties which in the end will have a larger return on investment.
When to Consider a 1031 Exchange
You can sell one property and buy another without doing a 1031 exchange. But you would then have to shoulder any tax implications that came with that real estate property exchange. So, why might you want to get involved in a 1031 exchange?
There are a few reasons to consider entering into a 1031 property exchange:
- Seek a property that has better ROI prospects
- Want to diversify your assets and use real estate to do it
- Seek to consolidate several properties into one
- For estate planning, you divide a single property into several assets
The biggest reason remains to defer the capital gains on the investment. By deferring the capital gains, it gives the investor more capital to make the next investment.
It’s worth noting that the IRS is constantly changing the laws associated with 1031 exchanges, and there are many rules to follow. If you want to enter a 1031 exchange, you should do it with the advice of a tax professional.
1031 Rules to Know
There are a few things to know about the 1031 exchange rules. The property that you replace the sold property with has to be identified within 45 days. You must also then complete the exchange within 180 days.
The replacement property you buy should be of equal or greater value than the one you previously sold.
Tax Implications of a 1031 Exchange
As was already mentioned, the reason to do a 1031 exchange is to avoid paying the capital gains you get when you sell a property. This allows you to take the money you make from the sale of a property and invest it in an equal or greater valued property to avoid paying the taxes.
Does that mean you never pay the taxes? Well, no, when eventually the properties get sold, and the money isn’t reinvested, then you would pay the taxes on the gains.
There are few ways you might get taxed in the process of a 1031 exchange. Say you have one million dollars in gains from the property sold. This money goes to a person called a qualified intermediary (more on this later) while you find the next property. If the next property’s mortgage only takes $900,000, the extra $100,000 is called boot.
The boot is the amount you pay taxes on to the IRS during a 1031 exchange. In this scenario, you’d pay taxes on the extra $100,000.
A person can also opt to take some boot from the sold property as cash or invest in another way. Again, the boot or money not reinvested into the next property is what is taxable.
Types of 1031 Exchanges
Real estate buying and selling is not like buying a pair of shoes after exchanging the wrong size ones. The process can take more time, and because of that, some different types of exchanges spell out how the property exchanges happen. Here are the different types of 1031 exchanges.
In a delayed exchange, property gets sold, but the replacement property or properties may be delayed. There are rules for how long the delay can be. More on this later.
In this scenario, one property gets sold, and the replacement property (or properties) are bought simultaneously without any delay, so funds don’t need to go to a qualified intermediary.
Delayed Reverse Exchange
In this type of exchange, the replacement property is actually purchased before the current property gets sold or relinquished.
Delayed and Build-to-Suit Exchange
In this type of exchange, the current property gets sold. Then there is a delay period while a new property built-to-suit the need of the investor.
Delayed and Simultaneous Build-to-Suit Exchange
In this type of exchange, the built-to-suit property is purchased/built before the current property is sold or relinquished.
Delayed Exchanges and Timing for a 1031 Exchange
One of the most important things to know about a 1031 exchange has to do with timing. The IRS has set rules related to how long you actually have to make the property exchange.
One thing to know about the property exchange is that it must follow the like-kind rules. This doesn’t mean they need to be the same. For example, you could sell a condominium rental property and buy land or an apartment building. You could not sell a rental condominium and invest in jewelry or stocks.
Remember, you have 45 days to identify your replacement property and 180 days to complete the exchange. There are a few rules also attached to identifying the exchange property.
Maybe you don’t know exactly what property you want to purchase yet. You can use the three-property rule. This means you can identify three potential properties within 45 days.
In the 200% rule, you can identify a whole host of potential properties, and the one catch is that their total value cannot exceed 200% of the property you have just sold.
With the 95% rule, you can identify again as many properties as you like. But once you purchase, their value is to be at least 95% of what you have identified.
Ineligible for a 1031 Exchange
There are a few scenarios where you can’t use a property for a 1031 exchange.
You can’t use your primary residence for a 1031 exchange. You would need to not live there for a period of time and show rental records to become eligible.
You also can’t flip properties using a 1031 exchange. The IRS code says specifically that a property held primarily for resale does not qualify for an exchange.
Costs Associated with a 1031 Exchange
As has been mentioned several times, you want a tax expert to make sure you are following the many rules associated with a 1031 exchange. You can use exchange funds for some of these expenses. These include:
- Broker’s commission
- Qualified intermediary fees
- Filing fees
- Related attorney’s fees
- Title insurance premiums
- Related tax adviser fees
- Finder fees
- Escrow fees
Other costs and fees that are not eligible for using exchange funds for include:
- Financing fees
- Property taxes
- Repair or maintenance costs
- Insurance premiums
You can have a mortgage on the property you sell and on the property your buy as a replacement. If the new mortgage is less than the previous mortgage, the difference is treated as boot and is taxable.
Primary Residences, Vacation Homes, and Second Homes for 1031 Exchange
Of course, the IRS has rules related to using the replacement property as your home, vacation home, or a second residence. The IRS has what’s referred to as the Safe Harbor Rules that relate to this issue.
Once you have the new property, the IRS will look at the two 12-month periods following when the property officially becomes yours. The property must be rented to another person at fair market value for at least 14 days.
You can’t use the dwelling yourself for more than 14 days during that period. Or you must 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Which States Don’t Recognize 1031 Exchanges?
The State of Pennsylvania does not recognize a 1031 exchange requiring you to pay them the tax on the capital gains.
Some states also have withholding exemptions if you’re not a resident of the state. These states include California, Colorado, Hawaii, Georgia, Maryland, New Jersey, Mississippi, New York, North Carolina, Oregon, West Virginia, Maine, South Carolina, Rhode Island, Alabama, Delaware, and Vermont.