One of the greatest wealth building tools available to an investor is the 1031 Exchange.
Internal Revenue Code 1031 gives an investor the ability to defer the payment of capital gains taxes when selling an investment property by reinvesting the proceeds from the sale, within certain time limits, in a property or properties of equal or greater value. This deferral process should be utilized by every serious investor to maximize their purchasing power and grow their portfolio.
Four Types of Exchange
Simultaneous
The relinquished property and the replacement property have concurrent closings.
Deferred
Most common type of exchange and allows flexibility. Sell first and then replace within 180 days.
Reverse
Replacement property is acquired prior to selling. An exchange accommodation titleholder must be utilized.
Construction
Use exchange proceeds to build on land or improve an existing property.
Like most real estate transactions, an experienced and knowledgeable team is critical. Investors should have not only their real estate broker, mortgage broker and attorney involved, but they should also be in touch with their tax accountant to ensure every detail is reviewed.
Deferred exchange is the most common and so worth diving into more detail. An investor must follow a few basic guidelines to complete a successful 1031 exchange.
Property Qualifications - The properties involved in the exchange must be held for use in a trade or business or for investment, and be in the United States. This excludes residential property you live in or intend to live in, as well as second homes or vacation homes. This also excludes properties you intend to immediately resell.
The replacement property or properties must be of like-kind. Like-kind refers to the nature of the investment rather than the form. Any type of investment property can be exchanged for another type of investment property. A single-family residence can be exchanged for a duplex, raw land for a shopping center, or an office for apartments. Any combination will work. It does not matter how many properties you are exchanging (1 property into 5, or 3 properties into 2) as long as the value, equity and mortgage are are of equal or greater value as the relinquished property.
Exchange Account - This account is setup with an exchange facilitator during escrow of the property being sold.
It is important to know that taking control of the cash or other proceeds before the exchange is complete may disqualify the entire transaction and make all gain immediately taxable. If cash or other proceeds are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property. By the way, you cannot act as your own facilitator.
Timeline - The exchange must be complete in 180 days. The timeline begins upon close of escrow of the relinquished property. The replacement property or properties must be acquired on or before the 180th day. The first limit is by the 45th day potential replacement properties must be identified. These potential replacement properties must be clearly described with its legal description or street address and submitted in writing. Investors must close on at least one of the nominated properties within the 180 days. These limits cannot be extended for any circumstance or hardship. The IRS provides a few rules for identifying replacement property:
• 3 Property Rule - Any three properties, of any price, anywhere in the United States may be identified.
• 200% Rule - Four or more properties can be identified, however the combined value of all the properties identified can not exceed 200% of the property sold.
• 95% Rule - Identify more than three properties with a total value that is more than 200% of the value of the relinquished property, and the taxpayer must acquire at least 95% of the value of the identified properties.
Reinvestment Requirement - To defer 100% of the capital gains tax liability, there are two requirements:
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Reinvest all the cash that was generated from the sale of the relinquished property and;
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Purchase property equal or greater in value to the relinquished property.
An exchange is not an “all or nothing” proposition. A partial exchange is possible and will result in a partial deferment of the tax liability. If the replacement property or properties can not be acquired on or before the 180th day, the exchange will fail and taxes must be paid.
