I recently started working with a client who is selling a rental and using the proceeds to purchase a second investment property. My advice to her was to consider a 1031-Exchange (AKA: Starker Exchange, or Like-Kind Exchange). She followed-up with a lot of questions and it inspired me to write this simple breakdown of IRS Code 1031 as it applies to real estate. This tax-deferment strategy, used by investors around the country, seems pretty straight-forward but one wrong move could cost you a much larger tax bill due next April.
What is a 1031-Exchange?
As defined in section 1031 of the IRS Code, a 1031-Exchange allows investors to use the proceeds from one sale as reinvestment in a “like-kind” property, while also deferring taxes due on capital gains from the sale[i]. The most important things to note are 1) this is not a tax-free transaction, it is tax-deferred; and 2) both the sale and purchase must be completed within a designated time frame to qualify.
Four Types of 1031-Exchanges:
SIMPLE – The most basic form, a simple swap of one property for another and closed on the same day.
DEFERRED – Offers more flexibility. A deferred exchange allows an investor to sell a property before purchasing a new one, and uses an Exchange Accommodation Titleholder (EAT) to hold the money in escrow between transactions. The transaction is bound by time limits, which I will discuss later.
REVERSE or FORWARD – This is the most complex exchange, where an investor purchases a new property before selling the trade-in. A forward exchange requires the services of an Exchange Accommodation Titleholder (EAT) – typically a title company – who holds title to either the relinquished or the replacement property until the exchange is closed. Also, this type of exchange typically requires all cash.
CONSTRUCTION or IMPROVEMENT[ii] – This exchange allows an investor to construct their “ideal” replacement property. This can include simple repairs and improvements to an existing structure, or be as complex as new-build construction. All improvements must be completed within a 180-day period.
What Qualifies as a 1031-Exchange?
᠅ Both properties bought and sold as part of the exchange must be used as an investment. Selling your primary residence and using the proceeds to buy a second home in the mountains does not qualify under this rule.
᠅ Both properties must be similar in nature, character, or class. Concerning real estate, this is pretty broad and inclusive. For instance, a piece of land with improvements (home, plumbing, etc.) would still be considered “like-kind” to vacant land.
᠅ The purchase price and/or new loan on the replacement property must be equal to or more than the sold property. Example: An investor sold a $500,000 property that held a $250,000 mortgage. Now, the investor must purchase a replacement property worth at least $500,000 using at least $250,000 in leverage.
A Few Caveats:
᠅ Real estate within the United States cannot be considered like-kind to any property outside of the US.
᠅ Improvements conveyed without land do not qualify as a 1031-Exchange (i.e. mobile homes).
᠅ Both real and personal property can be exchanged under the 1031 rule; however, real property cannot be exchanged for personal property or vice versa, and still claim tax-deferred status.
᠅ The following types of property are specifically EXCLUDED from 1031 tax deferment:
– Inventory or stock in Trade
– Stocks, bonds or notes
– Other securities or debt
– Partnership interests
– Certificates of trust
Time Is of the Essence
This is true of any contract deadline in real estate, but the IRS has also given strict time constraints on completing a 1031-Exchange. If the following two deadlines are not met, the entire gain will be immediately taxable. These deadlines cannot be extended for any reason except for a presidentially declared disaster.
DEADLINE 1: 45 days from the sold date of the first property, the investor must identify potential replacement properties.
᠅ Must be in writing and include legal description, street address, or distinguishable name.
᠅ Must be signed by the investor (you).
᠅ Must be delivered to another party involved in the exchange, such as the seller of the new property or another qualified intermediary.
᠅ Notice given to your attorney, real estate agent, accountant, or other similar agent role is not considered acceptable.
DEADLINE 2: 180 days allowed between the sale of the first property and the closing on the new investment. This means you have essentially six months to close the exchange to defer the taxes on your gain. It is also important that the final investment purchase matches the property submitted during the above 45-day deadline.
In the case of a reverse exchange, the title of the property to be sold can be placed with the EAT for up to 180 days while the investor finalizes the sale and closes the exchange.
What Not to Do
᠅ Do not take control of any proceeds before the exchange is complete. This could disqualify the entire transaction and make ALL gain immediately taxable.
᠅ You cannot act as your own facilitator. Here again, you will need to use the same aforementioned qualified intermediary.
᠅ Do not fall for sales pitch schemes promoting fake like-kind exchanges. These schemes often target non-qualifying vacation and second homes, referring to them as “tax-free” exchanges.
᠅ Do not neglect to claim the 1031-Exchange despite collecting proceeds from the sale.
There are a lot of useful ways to make this this tax-deferred investment strategy work for you. One of the most effective strategies, in my opinion, is to leverage the tax-savings from the sale of a high-value investment property to reinvest into multiple smaller properties in hot markets. A major benefit of a 1031-Exchange is that like-kind property in one market can be traded for like-kind property anywhere else in the country, without owing Uncle Sam. For example, a $400,000 rental home in Denver, CO incurring several thousand dollars in repairs each year, could be swapped for two high-end $200,000 investments in Dallas, TX under a property management company. This would save the investor not only thousands of dollars in maintenance each year but also man-hours spent managing his or her own properties.
Keep in mind, deferment will come due. When a 1031 investment is sold, not as part of another exchange, the original deferred gain plus any additional proceeds earned since its purchase, will be subject to taxation.
Please reach out to me if you’d like to discuss how this helpful tax tool can be used on your real estate investment portfolio. This article is for informational purposes only. I am not a tax expert nor an attorney. I recommend if you have further questions regarding the tax implications of a 1031-Exchange that you reach out to a qualified CPA.
[i] IRS, M. R. (2008, February 18). Retrieved from IRS.GOV: https://www.irs.gov/pub/irs-news/fs-08-18.pdf
[ii] (Equity Advantage. (2020, 06 15). 1031 Improvement Exchanges. Retrieved from 1031Exchange.com: https://www.1031exchange.com/improvement/)
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