1031 Tax-Deferred Exchanges
One Of Uncle Sam's Biggest Gifts To Real Estate Investors...
The phrase 1031 Tax-Deferred Exchange is a mouthful and those words alone can be very intimidating to some people. But if you're a real estate investor it's definitely something you should know about, for it could save you big-time when you sell a piece of investment property.
In layman's terms, a 1031 exchange allows a real estate investor to sell one property, buy another and defer capital gain taxes on the sale to a later date. And in certain instances, that 'later date' may eventually disappear altogether.
You probably already know that owner-occupants don't pay taxes on the first $250,000 (singles) or $500,000 (married couples) of profit when selling a home that they've lived in for two of the past five years. But that benefit only applies to your principal residence. When you sell an investment property, the entire profit is normally subject to capital gain taxes. And that can cause many investors to hold onto rentals that they'd rather sell.
And that's where the 1031 Exchange comes into play.
As long as you adhere to the time frames specified for such an exchange, you can sell one investment property and buy another while deferring the capital gain tax from the one you're selling. That profit essentially gets tacked onto the new property, so when you sell the replacement property down the road you'll have to pay the tax you deferred plus any profit on the new property.
But, if you keep the property until you retire, you might be in a lower tax bracket by that point. Or, if you eventually move into the new property and live there for two of the following five years, it would become your new principal residence. And assuming the aforementioned $250k-single/$500k-married exemptions still apply by then, all that accumulated gain might disappear altogether.
That's just what happened to one of our past clients. You can read their story in the Tales From The Trenches section of this website. They sold their Benicia rental and bought another rental property out of the area that would become their eventual retirement home. And by doing so they wiped out the capital gains tax from the sale of their townhome.
Finally, as noted above, in order for a 1031 exchange to be successful, you must adhere to strict time frames. Miss a deadline by one day and the sale immediately becomes a regular transaction without any tax-deferral benefits.
How a 1031 Exchange Works
Don’t embark on a 1031 Exchange without first consulting with your tax adviser to find out if a 1031 exchange makes sense for you.
In order for an exchange to be successful, you aren’t allowed to take possession of any of the sales funds. They are held for you by an Accommodator, who will then purchase the replacement home on your behalf and deed it back to you.
Anyone can be your accommodator — but in order to make sure you comply with the statutes governing 1031 exchanges and to ensure that your funds are safe with the accommodator, be sure to use a reputable 1031 Exchange Accommodator.
The contract on the investment property you’re selling should include a statement indicating that you’re doing a 1031 exchange.
Before escrow closes, your exchange company will prepare documents for you and the buyer to sign and will make arrangements with the title company to have your proceeds wired into its account. (Remember, you can’t receive any of the proceeds — they must be held by the accommodator until the purchase of your replacement home is ready to close).
Once the home you’re selling closes escrow, you will have 45 days to identify a suitable replacement property. There are several methods of identifying properties; the most common method is to list up to 3 different properties that interest you.
You can change the list as often as you’d like during the 45-day identification period. But once Day 45 arrives, whatever is on the list is cast in stone. And if you’re unable to purchase one of those three properties, the 1031 exchange goes away and your original sale is taxable.
It’s best to get into contract on your replacement home well before the 45-day identification deadline. For, imagine the dilemma you’d be in if after Day 45 you discovered structural problems on the property you were trying to buy, only to find out that the other two homes on your list were no longer available. You’d either have to proceed with your purchase or pull out of the transaction and lose your 1031 exchange.
If that happened before Day 45, you could simply put three new properties on your list and pursue one of them instead.
The purchase process is almost the same as if you were buying without an exchange, but with several important exceptions:
1) You must add a statement to the contract declaring your intent to purchase the property as part of a 1031 exchange; and,
2) You must sign exchange documents and have your exchange company wire the funds from the property you sold to the title company.
3) You must close escrow on or before the earlier of:
a) 180 days from the closing date of the property you sold, or;
b) the date income taxes are due for the year that your property sold
Since taxes are due April 15, if the property you sold closed between mid-October and December 31, you’d have less than 180 days to close escrow on a replacement property. If so, you could file an extension and wait to file your tax return until after the property you’re buying closes escrow. Either way, make sure you close by the 180-day deadline, for there’s no extension and no grace period. It doesn’t matter if Day 180 falls on a weekend or a holiday; miss it by one day and there’s no 1031 exchange.
As part of the closing process on the new property, the title company will have the property deeded from the exchange company to you, closing the loop and installing you as owner of the new property.
Although you made all the decisions and instructed the exchange company on what to buy, you never took possession of any of the funds, which is critical for a 1031 exchange to be successful.
In a 1031 Exchange, you must put every last cent from the property you sold into the new property and the purchase prices must match up. If you buy down and don’t use all of your equity from the property you sold, you’ll pay tax on the difference. That difference is known as Boot. There are a number of other situations where you could subject yourself to Boot. And that’s another reason to talk to your tax adviser before doing a 1031 exchange.
1031 Exchanges are also called Like-Kind Exchanges. That means you can exchange income real estate for income real estate but you can’t exchange real estate for diamonds or rare art. Nor can you exchange investment real estate for a principal residence or vacation home. But you can exchange a commercial building for an apartment building or a parcel of land. Again, always talk to your tax adviser before proceeding on a 1031 exchange and make sure that what you’re planning to do qualifies as a like-kind exchange.
Important Disclaimer: Before you rush out and jump on the 1031 exchange bandwagon, remember that everyone's tax situation is different, so be sure to consult with your own tax adviser to determine if a 1031 exchange will work for you. We're licensed to sell real estate but not to give tax advice, so please don't construe the information on this page or elsewhere in this web site as tax advice. It is designed only to be a general overview of how a 1031 exchange works and how some of our past clients have benefited from this oft-overlooked tool for real estate investors.