The Benefits of Making a 1031 Exchange with Investment Property
What is a “1031” Exchange?
First, “1031” stands for Section 1031 of the Internal Revenue Code. Section 1031 is actually a subset of Title 26 of the United States Code (USC). There are letters too – 1031(a), 1031(b), 1031(c), 1031(d), it goes on and on.
And…What do all those letters and numbers mean and how are they relevant to my property?
Basically, you can sell an investment property for other like-kind investment property and get tax relief. This means that when you sell “Real Estate” – you have to buy other “Real Estate”. Because “Real Estate” is a general term, it means you have a lot of options. Basically, any property in the US and US territories is like-kind with any other property as long it is held as an investment. You could sell a hotel and buy a plaza. You could sell a multi-family house and buy a car wash. With that flexibility, however, there are also very specific timelines you have to abide by in order to defer taxes. See below.
Why would I want to 1031 Exchange my investment property?
The US Government has written the IRS Code in a way that greatly encourages real estate investors to use the 1031 section of the Code to grow and improve their real estate portfolio. Instead of selling your property and paying the capital gains tax, you can roll the proceeds from the sale into an equal or greater valued property and defer the tax payment. There is no requirement to use all of the cash in an exchange, a partial exchange can assist with diversification if required.
Wait, what? I don’t have to pay taxes?
Right, as long as the replacement property is equal or higher in value than the sales price of the property you are selling, you can defer the capital gains tax associated with the sale. All 50 states recognize 1031 except for Pennsylvania. If you have debt on the property you are selling, this debt must be replaced in your purchase. Again, you don’t have to use all of the proceeds in your exchange to achieve a tax deferral.
Why would the Government do this? They love taxes.
There is a mutually beneficial outcome where investors reinvest into equal or larger projects. By keeping investors engaged, they continue improving property and supporting local contractors, supply stores and other professionals. Residents also benefit by the improvements to their local community. That translates into more jobs, more GDP, and more tax revenue. Have you noticed how many times you go to Home Depot during a renovation?
Are 1031 Exchanges new?
Not at all. The first 1031 exchange was completed over 100 years ago. The existing 1031 rules arose from the Revenue Act of 1921 (remember that one?). This Act allowed property to be sold and a replacement property purchased without taxing any capital gains on the property sold.
How do I actually accomplish this without paying taxes?
You need to work with a Qualified Intermediary (QI). They specialize in 1031 exchanges and are integral to making everything run smoothly. They also are required to handle the money. When you sell your property, the sales proceeds go to the QI’s escrow account. They then apply the proceeds to the purchase of the replacement property. They will keep you on the strict timeline required of the 1031 Code.
What is the timeline required?
There are two critical timelines that must be met:
Identification Period: You must select a suitable replacement property within 45 days of the sale of your property. You can use multiple Identification Rules to identify your property, the most common being the 3 Property Rule. This rule allows you to identify up to 3 properties of any value and you can close on one, two, or all three of the properties. Your Qualified Intermediary will help with the Identification Rules and the necessary paperwork for the Identification Period requirements.
Exchange Period: You must complete the purchase of the replacement property within 180 days of the sale of your existing property. The 45 day identification period happens within the 180 days – not in addition to.
What happens if I don’t meet the requirements?
You pay taxes on the sales proceeds. There are no exceptions or extensions other than a presidentially declared disaster in the area where you are purchasing property.
I don’t want to pay taxes if my deal falls through, tell me there is an easy solution.
There is! There are several configurations of investment real estate options that are passive in nature. Basically, instead of buying another property with your 1031 funds, you can invest in a property that is already owned and managed by the existing owner. Your funds can buy a share, a percentage, or an interest in a previously existing property. These properties have to be identified as backups on your Identification List to take advantage of the option.
Interesting, that sounds better than paying taxes…but why would I want to do that instead of buying my own property again?
These options allow you to combine your proceeds together with other investors to buy a larger or more expensive property – one that you may not have been able to afford on your own. Because ownership and management are already in place, you’ll have the opportunity to invest in a property that can be more passive and provide fixed returns. It’s also quicker and easier than a typical transaction.
Quicker and easier?
Yes, because banks are removed from the equation. Underwriting, appraisals, interest rate locks, and inspections (basically all the things that can slow down the process) are also now out of the picture. Because you’re buying a share and not the whole property, it only takes a few forms and can happen very quickly.
So there you have it, folks. 900 words ago, you were just learning the concepts and now you’re ready to make some moves. You’ve come so far! Please, feel free to reach out to Karen or I to see if we can help you with your Real Estate Investing goals.
Steve Spain: firstname.lastname@example.org
Karen Butz Webb: email@example.com
Morgan Legacy Partners, Inc. | Investor Relations
Karen Butz Webb, Esq. | Director
Steve Spain | Investment Strategist
436 E. 36th Street, Charlotte, NC 28205