What is a 1031 Exchange?
For lifelong real estate investors, the 1031 exchange can be the trick to help them save on taxes and build significantly more wealth. This post is the road map to making this happen.
What is a 1031 Exchange?
If a landlord decides to sell a rental property at some point, they will need to pay taxes on that gain. Now, this might not be a big deal if the property was a terrible investment or the investor had some bad luck and didn’t have any financial gain. But in those transactions that make a profit, Uncle Sam will come a-knockin’ for his piece of the pie.
Don’t fret, though. There is some good news: The IRS wants to partner with investors on that money by allowing a 1031 exchange. This technique is so-named because it’s outlined in Section 1031 of the Internal Revenue Code.
A 1031 exchange is a tax strategy named because of its inclusion in Section 1031 of the IRS tax code. It is also commonly known as a “Starker exchange” or a “like-kind exchange.”
In essence, a 1031 exchange allows an investor to “defer” paying any property taxes on the property when it is sold as long as another like-kind property is purchased using the profit received.
Changes to 1031 exchange rules
Understand that the 1031 exchange is not just for real estate investment purposes—but real estate is the most common use. The Tax Cuts and Jobs Act of 2017 limited these exchanges to “real property,” with some exceptions. The rule now applies “only to exchanges of real property that is held for use in a trade or business or for investment.”
This shouldn’t affect most real estate investors but may affect personal property sold with an investment property. It’s important to check with your accountant to determine if your 1031 exchange suits current laws.
The Benefits of the 1031 Exchange
The logical reason for the 1031 exchange makes sense. After all, if an investor makes $100,000 on a property and then uses that $100,000 to buy another property, it’s not like they are out spending $100,000 on shiny new toys. In fact, the money never even touches the investor’s bank account after the sale of the property but is held by an “intermediary.” So, in all its benevolence, the IRS has decided to be fair and not require that taxes be paid right now.
Even more than the tax-savings advantages, the 1031 exchange also has several other benefits. It can allow real estate investors to shift the focus of their investing without incurring a tax liability.
For example, perhaps a landlord is investing in low-income and high-maintenance properties. They could exchange the high-maintenance investment for a low-maintenance one without paying significant taxes. Or perhaps they want to move their investments from one location to another without the IRS knocking. The 1031 exchange makes this possible.
If the strict rules of a 1031 exchange are followed, the IRS allows investors to hold onto the money and reinvest it in another property. The taxes will still be due someday, but until then, it can be extremely advantageous to keep using the government’s money to invest in properties.
In addition to the government “partnering” with investors, the entire U.S. tax system is designed to encourage certain behaviors in society by rewarding or penalizing people for certain actions. In this case, the U.S. government rewards real estate investors for housing the masses.
Now it’s time to illustrate how a 1031 exchange works in the real world.
How Does a 1031 Exchange Work?
Below is the step-by-step process to carry out a 1031 exchange. The following is just a general outline, so specific deals will likely vary slightly from this process.
1. Decide to sell and do a 1031 exchange
Not every purchase is worth doing a 1031 exchange. After all, with all the requirements, costs, and countdown timers, it may be advantageous to simply pay the tax and move on. That is definitely a discussion to have with an accountant or tax adviser.
2. List the property for sale
The property for sale will be listed. The agent will likely include language in the listing paperwork regarding the seller’s desire to do a 1031 exchange and the buyer’s willingness to proceed with the process.
3. Begin looking for replacement properties
Remember, the moment the relinquished property is sold, the countdown of 45 days begins. Therefore, the investor should begin looking for deals immediately.
4. Find a qualified intermediary
The investor needs to look for someone professional with a good reputation.
5. Negotiate and accept an offer
When someone agrees to buy the property, the paperwork must clearly state that a 1031 exchange is taking place on the seller’s end, and the buyer will need to comply. Although there is not much work for the buyer to do, there may be paperwork they need to sign off on, such as assignments or disclosures.
6. Close on the sale of the relinquished property
The title company or attorney will handle the closing like any other real estate transaction, except the seller’s qualified intermediary will be actively involved in the process. And the funds will transfer to the intermediary’s bank account, not the seller’s.
7. Identify up to three properties within 45 days
It’s now time to officially designate the properties that are under consideration. Keep in mind up to three properties can be identified. Still, buyers are required to purchase 95% of the identified properties—or the total combined value of the identified properties is less than 200% of the sales price of the relinquished property.
8. Sign the contract on the first-choice property
Most likely, one of the three properties identified will stand out as the first choice. The buyer will need to get that property under contract and open escrow, ensuring the seller knows the purchase is through a 1031 exchange. Buyers can also go under contract on all three of the identified properties and use contingency clauses to back out on the properties the buyer chooses not to pursue.
9. Let the qualified intermediary work with the title company
The buyer, agent, and qualified intermediary will work with the title company or closing attorney to ensure all the i’s have been dotted and t’s have been crossed. This is a fairly simple process that any qualified intermediary should be familiar with.
10. Close on the replacement property
The beauty of the 1031 exchange is the ability to repeat this process over and over again on properties and continue deferring taxes indefinitely. This can help build some serious wealth over time, greater than simply paying taxes each time. One of the greatest benefits of the 1031 exchange is faster wealth growth.
1031 Exchange Rules, Regulations & Timeline
Some pretty strict rules must be followed for a 1031 exchange to get the tax-deferred exchange.
1. Properties must be “like-kind”
The IRS requires that the property being sold (the “relinquished” property) and the property being acquired (the “replacement” property) must be “like-kind assets.” In other words, car dealerships cannot be bought to trade for vacation homes, as they are different kinds of assets.
However, investors can exchange almost any type of investment property for any other type of investment property. You could exchange a duplex for an apartment complex, a piece of raw land for a rental house, or a vacation rental property for a strip mall.
Also, keep in mind that the property must be an investment, not a primary or secondary home. Additionally, both properties must be within the U.S. to qualify.
Finally, sorry, house flippers, properties that are designed for a quick purchase and resale do not count.
2. The replacement property should be of equal or greater value
In order to completely avoid paying any taxes upon the sale of a property, the IRS requires that the replacement property being acquired is of equal or greater value than the property being relinquished. However, that value could be spread out over multiple properties.
For example, let’s say a landowner has a real property that they want to sell for $1 million. To get the full benefit of the 1031 exchange, they must buy at least $1 million worth of like-kind real estate through the 1031 exchange. Now, that could be a +$1 million apartment complex or four different +$250,000 properties. It doesn’t matter. (Also note that acquisition costs, such as inspections, escrow fees, commissions, etc., do count toward the total cost of the replacement property.)
Technically, it is possible to carry out a partial 1031 exchange and purchase something of lower value, but taxes will have to be paid on the difference. For example, suppose the relinquished property is being sold for $1 million, and the investor purchases a new property through the 1031 exchange for $900,000. In that case, they will need to pay the normal capital gains taxes on the $100,000 difference. This extra $100,000 is known as “boot.”
Finally, understand that the sale price of the relinquished property is the entire sale and not just the profit made. In other words, if a property were purchased for $100,000 and then sold for $200,000, the replacement property would need to be greater than $200,000, not just the $100,000 in profit.
3. The 45-day identification window
The IRS imposes a very strict timeline for identifying the replacement property: 45 days. The investor must identify the property they plan to close on within 45 days or lose the entire benefit of the 1031 exchange. The clock starts ticking on the day that the relinquished property is sold.
Realistically, investors will have more time than just 45 days, as the timer doesn’t start until the day they sell their property. The property will most likely be listed for sale several months before closing, so investors should start looking for deals long before their property is officially sold.
Ideally, the day that the property is listed for sale is the day to begin searching, or as in the story with Serge above, consider selling an asset using the 1031 exchange after finding a new deal to purchase. Keep in mind investors can also negotiate a long escrow period on the property they are selling, giving them more time before the countdown begins.
In addition to the countdown the IRS places on real estate investors, there are some strict procedures to follow in this process. For example, investors are allowed to officially identify three potential deals, which is helpful in case the first one doesn’t go through. If only one property is identified and something happens later in the due diligence period, the investor might miss out on the entire 1031 exchange. The IRS generally allows up to three potential replacement properties—no more.
There’s always an exception to a rule.
There are a few exceptions to this rule, known as the 95% rule and the 200% rule. The first of these exceptions states that more than three properties can be identified, but the investor is required to purchase 95% of those identified. The second is that the total combined cost of all those identified properties is less than 200% of the sales price of the relinquished properties.
For example, if an investor formally identifies 20 potential properties, they would either have to purchase 19 of those—95% of the 20. Or the combined value of all 20 would need to be less than 200% of the sale price.
So what exactly does it mean to “identify” a property? According to the IRS:
“The identification must be in writing, signed by you, and delivered to a person involved in the exchange, like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant, or similar persons acting as your agent is insufficient.”
Once the properties have been identified, it’s time to move toward closing on those properties because another timer has already begun ticking…
4. The 180-day closing window
At the same moment that the 45-day window to identify a replacement property starts, another clock begins counting down too. It’s known as the 180-day closing window.
The IRS requires that the new replacement property be fully purchased (the title officially transferred) within 180 days of the sale of the relinquished property. This rule, along with the 45-day rule, is strictly enforced. The entire 1031 exchange will fail if both rules are not met.
5. Use a qualified intermediary
Finally, one of the most important rules governing the entire 1031 exchange process is this: The investor cannot touch the money of the relinquished property if they hope to avoid taxes.
Although there may be up to 180 days between the sale of the relinquished property and the purchase of the replacement property, the proceeds may never enter the investor’s bank account or an account controlled by the investor. Instead, they are required to use a qualified intermediary. An intermediary is someone who holds onto the money while the investor waits to buy the new property.
A quick Google search will yield the result of hundreds of companies that can serve as qualified intermediaries, also known as an accommodator. Investors should choose an established company that has a long history and solid reputation to avoid fraud or other unfortunate situations.
Also, keep in mind while the IRS doesn’t specifically state what a qualified intermediary is, they do define what a qualified intermediary is not. A qualified intermediary cannot be an investor, agent, broker, spouse, family member, investment banker, employee, business associate, or anyone who has had one of these roles in the past two years.
What Is an Example of a 1031 Exchange?
Here are two examples of BiggerPockets members who used the 1031 exchange to defer a lot of money on the sales of their real estate investments.
Example 1: Apartment building
In July 2013, Jason Mak purchased an 81-unit apartment building in Riverside, California. He paid $3.1 million for the property and immediately set out to improve the building. He worked on both the business side, evicting bad tenants and improving management efficiencies, as well as on the physical condition of the property. He added a new roof and elevator, painted, landscaped, and more.
After increasing occupancy from 60% to 95% and stabilizing the entire operation, Jason sold the property for $5.5 million in the spring of 2015. Overall, he netted a final profit of $2 million on the two-year apartment turnaround.
Had Jason simply sold this deal, he would have needed to pay close to $600,000 in capital gains tax, but he knew better. Jason used a 1031 exchange to parlay his cash into two new properties, a 24-unit apartment building, and an upscale office building. Although he reduced the number of units, Jason was able to buy nicer properties in significantly better locations that would be easier to manage and increase his ability to grow wealth.
Example 2: Single-family home
In 2012 Serge Shukhat purchased a newer single-family home for $70,000 in Casa Grande, Arizona. The home was a foreclosed property that quickly climbed in value. When Serge sold the home two years later for $135,000, he cleared almost $60,000 in profit.
According to Serge, he would have had to pay close to $15,000 in capital gains tax plus an additional $3,000 or so for the recapture of depreciation. Instead, Serge spent $600 on the 1031 exchange process and was able to roll his entire profit into the purchase of a newer, larger single-family home and a 2006 mobile home on one acre of land. Essentially, he turned one $1,000-per-month rental into two that gross a combined $1,950.
Serge also mentioned that this is the most typical 1031 deal that he does. He does not sell a home via 1031 until he has identified a replacement and then starts marketing the home with the lowest return on equity (not return on investment). This point is key. It is nearly impossible to source an adequate replacement in the short time period allowed, and the trade is worth it if the replacement is scored at a deep discount, which is rare and takes time.
He maintains a pipeline of turnkey investors ready to purchase the inventory that he wants to sell. He also continues properly managing these homes, adding another $100 monthly to the gross transaction. When it’s all said and done, Serge doubles the gross rental income and pays no tax in the process. It’s slow going, but he has used this method at least 15 times, and it’s an ideal way to build wealth slowly.
A 1031 exchange does not mean that landlords are selling their property to Jim and Jim is selling his property to them. In both Jason’s and Serge’s stories, investors are simply exchanging their property for another property (or multiple properties) with different individuals.
Contact RPM Central Valley
At RPM Central Valley, we specialize in property management for the Central Valley area.
To learn more about the services we can offer you, contact us today by calling (209) 572-2222 or click here to connect with us online.