You might think that the only path to upgrading or diversifying your real estate investment property holdings is through a standard sale and purchase. However, the 1031 tax-deferred exchange offers a host of opportunities for savvy investors to shift markets or categories, develop more robust portfolios, and control their tax strategies. This primer is designed to help you learn more about the 1031 exchange so that you can put it to work for you.
What is a 1031 Exchange?
The 1031 exchange is so-named because it is enshrined in Section 1031 of the Internal Revenue Service (IRS) tax code. The core of the rule regarding the exchange of property is:
No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.
In other words, by exchanging one property for another like-kind property, you are able to avoid paying taxes on any gains realized from the initial investment in the property you currently own. In order to take advantage of this strategy, however, you’ll have to conform to a number of limits and requirements in exchange for the benefits it offers.
Why Would you Want or Need a 1031 Exchange?
There are a variety of reasons that you might decide to take advantage of the 1031 exchange to manage your investment portfolio. These include:
- Trading underperforming assets for more profitable ones, either through exchanging for a different property type or a different market.
- Exchanging a number of single-family properties for multi-family properties in order to simplify property management and reduce costs.
- Shifting out of a management role by exchanging for properties that are currently under management.
- Moving from a residential investment strategy into commercial property investment.
It’s important to talk to your legal and financial advisors about your specific investment and tax strategy before embarking on a 1031 exchange. These pros can help you determine what type of exchange makes the most sense for your particular situation and your investment goals.
What is the Role of Depreciation for a 1031 Exchange?
The benefits of a 1031 exchange hinge in large part on the rules surrounding depreciation or, more specifically, what’s known as depreciation recapture. Each year, property owners are able to deduct depreciation on the properties they own. If the property then sells for more than its depreciated value, that difference may be recaptured, resulting in a larger amount of taxable income from the property sale.
By exchanging the property through a 1031 rather than selling it, investors can potentially avoid this additional tax burden. That allows them to continue to grow and develop their portfolio in new ways, while avoiding the tax implications on the profits generated during the process.
What is Boot?
No, we’re not talking about Timberlands. If there is a difference in value between the relinquished property and the new property, that difference is taxable and is referred to as “boot.” This difference can be impacted by a variety of factors, including outstanding mortgages on either property—as well as taxes, fees, and closing costs on either side of the transaction. It is essential to include all of the possible expenses in your calculations in order to avoid excessive boot.
Timing and Types of 1031 Exchanges
According to the IRS, while the exchange of properties doesn’t have to be simultaneous, it is ruled by two specific time limits in order to avoid taxation on the gains realized from the property being exchanged.
- First, you have 45 days from the date of sale of the relinquished property to identify a potential replacement property or properties. This must be in writing, signed by the investor, and delivered to the seller or a qualified intermediary (this could be your attorney, broker, CPA, or real estate agent—no family members though, sorry!). The replacement property must be clearly described, including a legal description and street address.
- Second, the replacement property must be received and the exchange completed within 180 days after the sale of the exchanged property or by the due date of the income tax return for the tax year in which it was sold. The replacement received must be “substantially the same as property identified within the 45-day limit”.
Delayed Exchange Exchanges that conform to the 180-day rule are called delayed exchanges, even though they are within the time limit. This is to differentiate them from simultaneous exchanges.
Reverse Exchange Property acquired before the relinquishment of the subject property can still qualify as an exchange property through a reverse exchange. In this case, the property must be transferred to a qualified intermediary or a special entity called an exchange accommodation titleholder. At that point, it becomes subject to the 45-day and 180-day rules governing 1031 exchanges.
Build-to-Suit Exchange If the property you have identified for exchange is currently under construction or renovation, it can still qualify. However, all construction must be completed within the 180-day period. Any subsequent building or improvement becomes personal property and is not considered part of the exchange.
1031 Exchanges and Estate Planning Goals
One of the most important aspects of a 1031 exchange is the ability to enjoy its tax benefits throughout your lifetime. Since inherited property is calculated at its stepped-up value for tax purposes, your heirs will avoid debt related to any of the deferred taxes. As always, talk to your financial advisor regarding your specific estate planning strategy and how your real estate investments fit into it.
Between expert advice and thousands of mortgage options for financing or refinancing your properties, Simplist has everything you need to make better choices. Whether you are an experienced investor or a first-time homebuyer, we’re here to offer the insight and product knowledge that matters most.