1031 exchanges are trades of investment properties for other investment properties that are similar in nature, meaning the same type of investment, but they can be different quality. These properties must have been initially purchased for investment purposes, and no other investments (such as stocks or bonds) qualify for these exchanges.
Named after the Internal Revenue Code and nicknamed by the IRS as “like-kind exchanges” because of the similarity of the two investment properties in question.
How do 1031 exchanges work?
The benefit of these 1031 exchanges is that the taxes from the trade can be deferred. These exchanges are transactions: you sell one investment property, and from the money you make on that sale, you must pay taxes. But if you buy a similar “like-kind” investment with the money you made from your initial investment, you can defer the taxes that you were going on the profits from you initial investment.
Often times the money that is made from selling an investment property can put the investor into a higher tax bracket, and these 1031 exchanges are legal way to circumvent an increase in personal taxes.
In simplified terms, the taxes that the investor would have to pay when selling off a property (usually a very substantial amount, especially for big and profitable investments) can be deferred and be reinvested. The table below illustrates a simple example:
A $2,000,000 Real Estate Investment
|$200,000||Costs associated with sale||$200,000|
|$1,000,000||Money left to reinvestment||$1,800,000|
*The numbers used for this table are arbitrary estimates and should not be referred to
What are the exceptions?
The money that counts as the difference in price between the two investments is called a “boot,” and cannot be deferred; must be paid taxes on.
Types of exchanges
There are five different types of 1031 exchanges, all with slightly different rules and regulations:
A simultaneous exchange is when one property is sold and the new property is acquired the same day. Additionally, the investor must employ a Qualified Intermediary to validate this process. Without a Qualified Intermediary, the investor does not qualify for the tax deferral.
Similar to a simultaneous exchange, a delayed exchange works the same way but escrow on the new property can be closed later than the first property’s sale date. However, escrow must be set up before the close of the escrow of the first property. The new property must be identified within 45 days of the sale of the old property, and it must be acquired within 180 days or by the tax return filing date (whichever is first). And all the money made from the sale must be reinvested.
With reverse exchanges the investor can buy a new property before selling the old one, but the investor cannot hold the two titles at the same time, so they must hire an Exchange Accommodation Titleholder to hold one of the titles. There are two ways that these reverse exchanges can work:
-Last- At the end of the escrow process, the title of the new property is transferred to the Exchange Accommodation Titleholder. After this event, the investor is given 45 days to sell the old property. At the end of escrow of the old property, the Exchange Accommodation Titleholder signs the new property over to the investor.
-First-The Exchange Accommodation Titleholder gets the old property transferred before the end of escrow of the new property. Once this happens, the investor has 45 days to sell the old property.
Build to Suit
To increase the value of the new property, the investor can build themselves a new property or make repairs to an existing one. This is a very complicated process and requires the help and cooperation of a Qualified Intermediary.
Exchanges can be made with other items bought for business or investment purposes such as boats.
Rules for the New Property
From the time that the old property closes, the investor has 45 days find a new property.
Up to three properties can be considered for the new property and presented to the intermediary.
If more than three properties being officially considered, the combined value cannot be greater than twice the value of the old property.
For more information on 1031 exchanges, please set up a meeting with Elena Vlyasuk.