When the time comes to sell your property, there are more questions than just what your asking price should be and how quickly you can close. Property sales can trigger significant tax consequences. Taking the time to minimize those effects can help save you thousands of dollars. One of the most valuable tax deferment methods for a real estate investor is the 1031 exchange.
The Basics of a 1031 Exchange
The name can make it sound complicated, but a 1031 exchange is a relatively straightforward method of deferring taxes on a property sale. It gets its name from Section 1031 of the U.S. Internal Revenue Code, which is the policy that makes this tax deferment possible.
With a 1031 exchange, you sell one investment property and reinvest the proceeds in another property of equal or greater value. If you do this within the allowable time frame, you avoid paying capital gains tax on the profit.
Typically, if you sell a house that cost you $200,000 a few years earlier for $300,000, that $100,000 in profit is taxed as capital gains. If you use that $100,000 to purchase another property for $320,000 via a 1031 exchange, you defer paying the capital gains taxes that would otherwise be due at the time of the sale on that $100,000 in profit.
You may see the property you are selling referred to as “Phase 1,” “downleg,” or “relinquished property,” and the new purchase called “replacement property.”
Using a Qualified Intermediary
One critical provision of the 1031 exchange rules is that you must use a qualified intermediary. That means that proceeds from your sale don’t come directly to you. They go to the qualified intermediary, a company or person that holds the funds for you until they are transferred to purchasing the replacement property.
You no longer qualify for a 1031 exchange if you receive the funds from your sale, even temporarily.
Verifying the intermediary will safely hold your funds in an FDIC-insured account is crucial.
The qualified intermediary’s duties include the following:
- Coordinating with you on the exchange
- Accepting the funds from the relinquished property and depositing them into an insured account used only for money from the exchange
- Providing documents and instructions to the escrow and title company during the sale
- Holding information about properties you are considering for your replacement purchase
- Transferring funds from the sale to the escrow company facilitating the purchase of the new property
- Conveying to you the title of the replacement property
- Keeping detailed records and providing them to you
- Reporting interest earned on the escrowed funds to the IRS, if necessary, via a 1099 form provided to you
The Like-Kind Requirement
The IRS requires the properties involved in a 1031 exchange to be “like-kind.” That may make it sound like when you sell a single-family investment property, you must exchange it for another single-family property. Thankfully, the rules aren’t that strict.
You may exchange any property owned for investment purposes for any other investment property. That means you could sell a house and purchase an apartment building, farm, retail space, or office building, among other options.
Examples of properties that do not qualify for like-kind exchange are stocks, properties intended for immediate resale, partnership interests, or your personal home unless a portion of that is a business property.
There are stringent timelines to which you must adhere with a 1031 exchange. Failure to do so will make your transaction taxable.
You have 45 days from the sale of your property to identify potential replacements. The details of potential replacements must be shared, in writing, with your qualified intermediary.
Within 180 days of the sale of the relinquished property, or the date your tax return is due, whichever comes first, you must close on the sale of the replacement property.
How to Execute a 1031 Exchange
Step 1: Identify the Properties You Want to Buy and Sell
This one is pretty straightforward. Decide which of your investment properties you want to sell. Most people use a 1031 Exchange to update to a larger or more upscale property or one with better cash flow.
Then identify properties you want to buy. They must fall under the “like-kind” rules discussed above.
Step 2: Choose Your Qualified Intermediary
You will want to work with someone who has experience with 1031 exchanges since missed deadlines or mishandled money could mean you no longer meet the IRS requirements to do an exchange.
Once your property sells, they will hold the funds in an escrow account until you close on the new property.
Step 3: Report to the IRS
Using IRS Form 8824, you need to report the 1031 exchange when you file your tax return. This is how you notify the IRS that you’ve made the exchange, and where you provide information on the types of properties, timeline, qualified intermediary, and the money involved, in order to show that you met the requirements for a 1031 Exchange.
The 1031 exchange is a fantastic tool in your real estate investing toolbox. It can help you grow your real estate portfolio more quickly by deferring capital gains taxes. Because the IRS guidelines can be complicated and the timelines unforgiving, you will need to stay on top of the process and make sure your qualified intermediary has experience with the process and help you avoid any mistakes. If you feel uncertain about the process, consider working with a real estate investment company that can walk you through your 1031 Exchange and help you identify money-making replacement properties.