In the current market, there are more and more real estate investors looking for professional property managers who can help them get the most out of their real estate investment.
They are looking for property managers who know how to help them reach their goals, so as a property manager, it is crucial to be aware of all the ways that you can do just that. This includes having the financial knowledge required to help your clients, and we recommend familiarizing yourself with the 1031 tax exchange and all of the rules that go with it.
While most established real estate investors and property managers are probably aware of this tax opportunity, it is always good to brush up on your facts or dive deeper. So in this article, we will be going over everything that you need to know about the Internal Revenue Code 1031 tax exchange.
First, we will talk about what this actually entails for real estate investors. Then, we will go over the property requirements for the 1031 tax exchange, and what properties will be considered “like-kind”.
Then, we will describe the basic calculations needed and the three different types of 1031 exchanges that you can benefit from. Finally, we will go over some of the rules that a property owner needs to follow to properly execute a 1031 tax exchange.
So, if you’re ready, let’s dive into the 1031 tax exchange and how it can be helpful for savvy real estate investors and property managers alike.
What Is a 1031 Exchange?
If you aren’t already familiar with the concept of the Internal Revenue Code 1031 tax exchange, it is luckily quite simple. This exchange allows real estate investors to defer capital gains tax on investments.
All they have to do is reinvest the funds from the sale of a property into a like-kind investment. Since it can result in a large amount of savings for investors, the 1031 exchange tends to be one of the most popular sections of the federal tax code.
With this exchange, it is important to note that you are deferring your capital gains tax, rather than eliminating it completely. The property that you end up receiving in the exchange is treated as a continuation of the investment property you sold, meaning that you are then able to postpone the recognition of gain.
So, you can defer capital gains taxes you would typically have paid on the funds you received from selling the property, and instead shift to owning a new property.
What Are the Property Requirements for a 1031 Exchange?
In order to qualify for the 1031 exchange, you will have to be purchasing a business or investment property. Your primary residence would not count towards a tax-free exchange. It must also be “real property”, which is defined as a parcel of land and everything that is permanently a part of it, such as buildings.
This means that investment property owners can use this tax-free exchange specifically for rental properties, or a business can use it for office buildings or other business-related property.
A like-kind exchange also cannot be used for anything other than to exchange real property. For example, you can’t take advantage of a tax-free 1031 exchange for personal property such as a car.
What Is Considered “Like-Kind” When It Comes to Real Estate?
The IRS has specific rules for what is considered a like-kind property if you wish to take advantage of the 1031 exchange. According to the IRS, like-kind properties will be the same in nature or character, even if they may differ in quality or grade.
In the United States, all real estate that is owned for business or investment purposes is considered to be like-kind, regardless of the type, location, or condition. For example, an apartment building in Tennessee could be considered like-kind to an office building in California.
1031 Exchange Basic Calculations
To get a fuller picture of how to pull off a 1031 exchange, let’s create an example.
Let’s say that a few years ago, you invested in a single-family home for $300,000. Today, it has appreciated in value and is worth $500,000. You decide that it is finally time to sell the investment property.
Rather than paying a capital gains tax on the $200,000 that you have made from the property appreciation over time, you could use the 1031 exchange to place the income you gained from the sale of the single-family property into another rental property. This would allow you to defer capital gains tax.
In theory, you could continue to do this multiple times over the years and keep exchanging your rental properties for like-kind properties that are of equal or greater value than the last. This way, you won’t have to pay taxes each time you exchange one investment property for a new property.
However, at some point, you may want to sell the investment property for cash instead of simply exchanging it for a new property. When you decide to do this, then the original deferred gain, plus any additional gain that has occurred since the last exchange, will be subject to tax.
Let’s go over another example. Let’s say that five years after your property exchange, you are able to sell your investment for $800,000 cash. Now, since you are not immediately investing all of the funds into a new property, you will need to pay taxes.
In fact, you may need to pay quite a lot of taxes since you now have a total of $500,000 of long-term capital gain since you only paid $300,000 for your original property.
While this process may seem simple, trust us when we say that there are other complexities to be aware of before you dive into your first 1031 exchange.
For first-timers, taking a look at all of the rules may seem off-putting or overwhelming, but we promise that even though the process has a few more rules to consider, we are confident that with some research and time, you will be able to pull it off.
So, keep reading to find out more about what you need to know before you head into a 1031 exchange.
The 3 Types of 1031 Exchanges
When you or your clients are looking to make a like-kind tax-free exchange, there are three different methods that you can use to make it happen. Let’s take a look at them:
1. Deferred or Delayed 1031 Exchange
This kind of 1031 exchange is the most common among savvy real estate investors. However, it is important to note that there is a specific timeline that one must follow if they wish to go through with this process.
In this method, the buyer would close on the sale of their property. Then, they will have 45 days to identify which property they will buy as a replacement property.
For the replacement property to qualify for the 1031 exchange, it must meet one of the three following criteria:
- The Three Property Rule: The investor may choose up to three different properties as a potential replacement property for their original investment within the 45-day period. This is regardless of the total fair market value of the new properties.
- 200% Rule: The investor may choose an unlimited amount of replacement properties as long as the total fair market value is not above 200% of their original property.
- 95% Rule: An investor is able to exchange as many investment properties as they want, as long as they receive at least 95% of the value of their new properties before the end of the period given.
If a property owner wants to participate in a 1031 exchange, they will also have to close on their replacement property within 180 days of the sale of their original property. This, in addition to the 45-day limit on identifying a replacement property, is a critical deadline to keep in mind if you are trying to pull off this tax-free exchange.
Our top tip for reducing your risk with these timelines is to have a replacement property already lined up before you close on the sale of your original property.
If you are looking to speed up the process, or are having trouble finding a replacement property to invest in, you can always hire a professional exchange company (also referred to as accommodations or facilitators) to help handle the transaction.
Finally, if they want to make this exchange work, real estate investors will need to involve a qualified intermediary. Essentially, a qualified intermediary is a third party who is there to hold the funds from the original sale in an escrow account. These funds will be held in this account until the investor finds their replacement property and closes on it.
If an investor were to handle the funds themselves or touch them in any way, they would violate the 1031 exchange rules and could end up owing taxes on the funds.
2. Simultaneous Exchange
If the investor closes on the property that they have decided to sell and then closes on their new investment property immediately (typically within one day), it is considered a simultaneous 1031 exchange. In this case, the purchaser may use a qualified intermediary if they want to, however they are not required to.
3. Reverse 1031 Exchange
A reverse 1031 exchange is almost exactly what you would imagine it would be based on its title. This method occurs when a new replacement property is purchased before the sale of the original property is completely closed. It is essentially a backward version of the standard 1031 exchange.
Now that you are aware of the three different kinds of 1031 tax exchanges, let’s go over some of the additional rules that may come up should you decide to take advantage of this tax-free way to gain a new investment property.
Additional Rules to Know About the 1031 Exchange
Generally, anyone who wants to take advantage of the 1031 exchange should remember that the new property they plan to acquire must be of equal or greater value to their original one. To put it simply, you essentially want to trade up without the ability to cash out from your sale.
In some cases, a 1031 tax exchange could include a property that may not technically be considered a like-kind property. For example, the sale of the property may include an additional cash payment for the purpose of making capital upgrades at the new replacement property.
This is referred to as a boot. Since the cash is not considered to be like-kind to the original sale, the investor may need to pay taxes on the boot portion of the funds.
Bottom Line
There are many reasons why an investor may want to take advantage of a 1031 tax exchange. Maybe they want to put off paying their capital gains tax for the time being, or they want to consolidate multiple investment properties into one, larger asset. They may even simply wish to shift their investment from one area to another.
Whatever the reason is, it is important that any professional property manager is familiar with what a 1031 tax exchange is and how to pull it off. That way, you will be able to provide higher-quality services to your clients and help them reach their investment goals.
As long as you know the ins and outs of this process, we don’t doubt that you will be able to navigate the rules and successfully help your clients navigate the 1031 tax exchange.
If you have any further questions on how to pull off a 1031 tax exchange, or if you need anything else to help you reach your goals in real estate, we can help. Contact our team at Blanket to find out more.
