A 1031 Exchange or Like-Kind Exchange allows you to roll the gain from your old property into your new one. The IRS treats this transaction as a continuation of the original investment. It is not considered a sale of the property and therefore doesn’t trigger capital gain taxes or depreciation recapture taxes.
In The Real Estate Investor’s Tax Strategy Guide, Kramer, and Kramer state, “There is almost nothing else in the tax code that compares to the potential wealth multiplying the effect of a like-kind exchange.”
Full disclosure, I am not a CPA or a 1031 exchange expert. This post, like all my posts, is meant to shed light on an aspect of real estate investing that you could utilize in the future if it works into your strategy and plan.
History of the 1031 Exchange
Illustrating the history of the 1031 exchange allows you to understand it a little more. Like-kind exchanges have been around since the early 1920s. In the beginning, the “buy” and “sell” were required to be simultaneous. This made a like-kind exchange almost impossible.
In the 1970s, TJ Starker and his family challenged the need for the “buy” and “sell” transactions to have to be simultaneous. Their case went all the way to the US Tax Court and it was decided that delayed exchanges were allowed.
Section 1031 of the Internal Revenue Code states, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or an investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or an investment.”
Sounds simple enough, but there are 6 very important rules that you have to abide by and every form has to be filled out completely and correctly or your 1031 exchange could be audited and denied.
BOTH Properties MUST be Investment Properties
The first rule is both the property that you sell and the one you purchase must be “held by you for an investment”. This is fairly straight-forward, however, it can't appear to the IRS that your property was intended to be a flip all along.
Garret Sutton, Esq, in his book Loopholes of Real Estate says that the tax court opinions typically require a “two tax year” holding period. He goes on to explain that this creates a problem though because Jan 1 of year one Jan 1 of year two is two tax years. December 1 of year one to Jan 1 of year two is also two tax years. He says that the IRS tends to favor a year and a day test, meaning that a year and a day from any point in time, will get you to a new tax year.
45-Day Identification Period
From the day that you close on selling your former property, you have exactly 45 days to submit a list of properties that you are interested in pursuing. Keep in mind, these are calendar days and there are no extensions.
Keep your list to 3 properties or less. The tax code in 1031 says that if you put more than 3 properties on your list, then you become subject to the 200% Rule which states that since your list is more than 3, your combined purchase price of everything on the list cannot be more than twice the selling price of your old property.
180-Day Reinvestment Period
From the day that you close on selling your former property, you have exactly 180 days to take the title in your name on the new property. The property has to be from your 45-Day list. Again, these are 180 calendar days and there are no extensions.
The title to the new property has to be submitted to your intermediary by midnight on the 180th day. One thing to keep in mind here is if the exchange goes past April 15th, the deadline to file your taxes, you will need to file for an extension to get the 1031 exchange completely within the tax year that you started the exchange.
A Qualified Intermediary is Required
You are not allowed to hold the funds from the sale of your first property until you purchase your new property. The funds have to be held by a third party called a qualified intermediary. Typically qualified intermediaries are companies that specialize in handling 1031 exchanges. They handled all the paperwork for the 1031 exchange as well as hold the funds during the exchange.
Don't skimp on your qualified intermediary. If there's any advice you get out reading this post, this is it. Hire a company with many years handling 1031 exchanges. The problem is almost anyone can call themselves a qualified intermediary. Very few states require qualified intermediaries to be licensed and there are no federal standards.
If I were hiring a 1031 exchange company for the first time, I would ask the following questions:
Is your company bonded and insured against errors and omissions and employee dishonesty?
Do you require me to sign a “hold harmless” agreement?
Where will my funds be held during my exchange?
Who has access to my funds during my exchange?
Request to see their financial statements.
All of these questions are designed to get at one point…how safe will my money be during the exchange. You want to make sure that it is guarded against unscrupulous employees, creditors and is held within the rules and statutes of the Internal Revenue Code Section 1031.
One of the more important rules of holding the funds is to make sure that they hold it in a completely separate account from the very first day it is deposited through to the dispersal of the funds.
Taking Title in the Same Name
How you hold title on your old property needs to match how you take title on your new property. For example, if you hold title in your name on the old property and want to take title in your newly created business entity you can't.
The deed for the new property has to be recorded in the same name and tax identification number that the old property was recorded in. This makes sense because both the sale and purchase have to land on the same tax return.
Avoiding Taxes in a 1031 Exchange
To avoid taxes in a 1031 exchange, first, you have to reinvest all proceeds from the sale of the first property into the next one. Second, the property that you are purchasing has to be more expensive than the property you're selling.
The calculations can get complicated when there's financing is involved. You have to calculate everything out if you want to avoid taxes altogether. For example, if you are selling a $100,000 house with a $70,000 loan you will need to reinvest the full $30,000 into the next house. Another way to look at that $30,000 is as a down payment, so your new loan may not be a typical 80% of the home value.
Keep in mind that the gain that you experienced from the previous property does not disappear, it carries forward to the new property. If you end up selling the new property, you would have to pay capital gains on the previous property gain in addition to the new property's gain.
Unused depreciation losses or carryover passive losses also pass through to the new property.
You can take cash out of a 1031 exchange. However, this will trigger a tax event for both long term capital gains and depreciation recapture. You can use your unused depreciation losses or your carryover passive losses to offset this gain in the same tax year. It is best to sit down with your account and go over all the numbers and options before you even list your original property for sale.
Those are the basics of 1031 exchanges. I think they are worth understanding and seeing if it makes sense working them into your retirement and estate planning. It is imperative that you discuss a transaction of this nature with your CPA and estate planner prior to listing your property. At the very least you need to speak to him or her prior to submitting your list of possible properties to purchase.
If you want to delve even deeper into 1031 exchanges, I recommend Gary Gorman's book, Exchanging Up.