The Basics of a 1031 Exchange in Real Estate
If you are a real estate investor who is considering selling your property, the 1031 exchange may be a good option for you. As with many things when taxes are concerned, the 1031 tax exchange can be somewhat complicated. That is why we put together this guide for you with everything you need to know about the 1031 tax exchange.
What is a 1031 Exchange?
A 1031 exchange allows investors to trade one investment property for another and defer the capital gains tax that they would have to pay when they sell the property. Investors who want to upgrade their investment properties like using the 1031 exchange for it, because they can get their new properties without having to pay taxes for the proceeds of the sale. The reason it is called a 1031 exchange is that it refers to Section 1031 code from the Internal Revenue Code (IRS).
1031 Eligibility Requirements
There are some rules and regulations for a 1031 exchange that determine if a property is eligible for an exchange.
- The new property has to be like-kind or of equal or greater value to the property you are exchanging.
- The properties have to be similar in function and nature. For example, a vacation home is not like-kind to a rental property or apartment building.
- All funds from the sale have to be held in escrow; you cannot hold any of the money from the sale.
- You need to find a replacement property within 45 days of the sale of your property.
- You have to close on the sale of the replacement property in 180 days of closing on the property you sold.
Who Can Take Advantage of 1031 Exchanges?
Any person who is a taxpayer that is selling real estate either as an investment or for a business or trade can use a 1031 exchange. The building owner cannot be the occupant of the building, though.
How Does A 1031 Exchange Work?
When selling a building, you can use the 1031 exchange by putting the proceeds from your sale toward a like-kind sale, which is a property that is similar to the one you are selling. You can use this to avoid the capital gains tax because you are not getting the proceeds from the sale, so there is no profit to tax. Here is how it works.
Find the Properties to Buy and Sell
As we mentioned earlier, the properties you are exchanging have to be similar to one another in order to qualify for 1031.
Hire an Intermediary
Since you cannot hold the money you get from selling the property in the exchange, you need to hire a qualified intermediary who will facilitate the exchange for you. They hold the money from the sale in escrow until you close on the purchase of the property you are buying. Take the time to research intermediaries in your area before hiring one to ensure you are hiring someone you can rely on who has experience with 1031 exchanges.
Report Your Exchange to the IRS
Once you finish the exchange of properties, you need to report the exchange to the IRS. You can do this by filling out Form 8824 when you fill out your tax return.
How long do you have to hold a 1031 exchange property?
There is not a specific amount of time that you have to hold the investment property before you can do a 1031 exchange. However, the government has proposed a holding period of one year several times. The IRS has also indicated they would prefer a one-year minimum, but currently, there is no hard rule in place.
Types Of 1031 Exchanges
There are various types of 1031 exchanges that work in different ways. Let’s take a look.
Delayed exchange
Delayed exchanges are the most common type because they allow you up to 180 days to buy a replacement property.
Reverse exchange
A reverse exchange is also called a forward exchange, and it means that you are closing on the purchase of a property before you close on the sale of the property you are exchanging it for.
Build-to-suit exchange
The built-to-suit 1031 exchange is also called the construction or improvement exchange. With these, the deferred tax money can be used to renovate your replacement property. You have to complete the renovations within 180 days.
1031s for Vacation Homes
You can use vacation homes for 1031 exchanges, but the IRS has strict rules regarding this. If you turn your vacation home into a rental property with a tenant, you are turning the vacation home into an investment property. The property cannot be for personal use in order to qualify for the 1031 exchange.
What qualifies for a 1031 exchange?
A property that qualifies for a 1031 exchange has to be an investment property or used for a business or trade. These include:
- Apartment buildings
- Vacant lots
- Commercial buildings
- Industrial buildings
- Rental homes
While a single-family home can qualify for a 1031 exchange, it is important to note that it cannot be the owner’s primary residence or vacation home.
Tests that determine if a property qualifies
There are three tests that can be done to determine if a property qualifies for a 1031 exchange.
Qualified Use Test
Qualified use is also known as productive use in 1031 exchanges. Productive use means that the property has to be used for the intended purpose when purchased. For example, if you are exchanging one rental property for another, you need to follow through with making that property a rental in productive use. If you were to move into that property after closing instead of making it a rental property, the IRS would require you to pay the capital gains tax.
Like-Kind Test
As we mentioned earlier, for the 1031 exchange, you have to be exchanging two like-kind properties. The two properties need to be similar in use and intent and must be for investment in some form, never for personal use. According to CWS Capital, “Vacant land can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential. But you can’t exchange real estate for artwork, for example, since that does not meet the definition of like-kind.”
Leaseholds and Coops
A leasehold can be considered a like-kind building with a fee if there are over 30 years left on the lease and has options to renew it.
According to the American Bar Association, “coop is not real estate in the conventional sense; rather, it is stock in a corporation which owns the land upon which the project is located and a space lease of the apartment. A coop is deemed real estate in jurisdictions which recognize it as such however, so it can be exchanged, but it is treated as leasehold property, so if the apartment lease has less than 30 years of term, it can only be exchanged for a leasehold.”
Is it worth doing a 1031 exchange?
If you are an investor, 1031 can be worthwhile for you because you do not have to pay the capital gains tax.
Conclusion
The 1031 exchange is a complex part of the IRS tax code, but it can be beneficial for a real estate investor who is looking to buy and sell investment properties.