An influential 1031 Exchange can help real estate investors grow their portfolios and increase their net worth faster and more efficiently than they could otherwise. Is a 1031 Exchange what it sounds like, how does it work, how does it differ from other types, and how can you avoid common errors? The six steps below will give you all the information about 1031 Exchanges. Click here to learn more about 1031s for commercial assets.
#1: Know what a 1031 exchange is according to the IRS
Like-kind exchanges are defined in Section 1031 of the Internal Revenue Code as exchanging investment or business real estate for a property of the same type or “like-kind.” The Internal Revenue Code had allowed this strategy since 1921, when Congress passed a law preventing taxation on ongoing investments in property and encouraging active reinvestment. Like-kind exchanges are generally not required to be reported under the Internal Revenue Code unless the investor receives other property that is not like-kind or if the parcel was primarily held for sale and not for business purposes.
#2: Identify 1031 exchange-eligible properties
If the quality of the property is different from the one being replaced, the IRS considers it like-kind if it has the exact nature or character. The IRS believes it is like-kind property regardless of how real estate is improved.
A new law passed in 2017 eliminated tax-deferred exchanges of personal and intangible property. Patents, intellectual property, machinery, equipment, artwork, collectibles, and patents include these items.
#3: Identify the Five Most Common 1031 Exchange Types
There are five types of 1031 exchanges used by real estate investors. Among them are:
As soon as possible, one property is sold-or relinquished-and a replacement property (or properties) is purchased.
An exchange co-occurs with selling the present property and buying the replacement property.
It is necessary to purchase the replacement property before the current property is repossessed in a delayed reverse exchange.
Building a new property to suit the investor’s needs as part of a delayed build-to-suit exchange.
Purchasing the constructed property before the current property is sold in a delayed/simultaneous build-to-suit exchange.
#4. These are the three most important rules for 1031 exchanges
Tax-deferred exchanges require planning. Following these three rules is the key to a successful 1031 exchange:
- It is recommended that the replacement property is at least as valuable as the one being sold
- It is necessary to identify the replacement property within 45 days
- Within 180 days, you must purchase the replacement property.
#5. The Real-World Workings of 1031 Exchanges
In the real world, here’s how a 1031 exchange works. Let’s assume five things to keep things simple:
- Multifamily properties currently have a cost basis of $1 million
- The building’s market value is $2 million
- There is no mortgage on the property
- Exchange funds can be used to pay commissions and escrow fees
- Capital gains taxes are imposed on property owners at a rate of 20%
#6: Ensure that Capital Gains Tax is permanently eliminated
1031 exchanges defer or postpone the payment of accumulated capital gains tax. What happens to a real estate investor’s property when they die?
When real estate is transferred to an heir, it is revalued or stepped up to fair market value, eliminating any deferred capital gains taxes. Life is full of certainties, including death and taxes.
1031 exchanges are like interest-free loans from the IRS. Capital gains are not taxed, so real estate investors can use the money immediately to increase their rental income.
