What Is a 1031 Exchange?
If you own investment property and are contemplating selling it and buying another property, the 1031 tax-deferred exchange is crucial. It allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. Let’s take a look at 1031 exchanges —rules, concepts, and definitions you should know if you’re thinking of getting started with a section 1031 transaction.
What is a 1031 Exchange?
It’s essential to start with the basics in the financial field that is heavy with specialized terminology,
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, and it allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within specified time limits in a property (or multiple properties) of like kind and equal or greater value.
Who Are Qualified Intermediaries?
Under section 1031, any proceeds from the sale of a property remain taxable. For that reason, proceeds from the sale have to be transferred to a qualified intermediary, as opposed to the seller of the property, and the qualified intermediary then transfers them to the seller of the replacement property or properties. A qualified intermediary can be a person or company that agrees to facilitate the 1031 exchange by holding the transaction funds until they can be transferred to the seller of the replacement property. The qualified intermediary is not allowed to have any other formal relationship with the parties exchanging property.
Why Do You Want a 1031 Exchange?
As an investor, there are a variety of reasons why you may consider utilizing a 1031 exchange, including:
You want to diversify assets or find a property that has better return prospects
- You are the owner of investment real estate and are looking for a managed property rather than managing one yourself.
- You want to consolidate several properties into one or conversely you want to divide a single property into several assets.
- You want to reset the depreciation clock (more on that soon)
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.
It’s important to keep in mind when you are considering a 1031 exchange that they may require a comparatively high minimum investment and holding time. This makes these transactions ideal for individuals with a higher net worth and because of their complexity, 1031 exchange transactions are best handled by professionals.
Why is Depreciation Important to a 1031 Exchange?
Depreciation is a critical concept for understanding the full benefits of a 1031 exchange.
Depreciation is the percentage of the cost of an investment property that is written off every year, while taking into account the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which includes the property’s original purchase price, plus capital improvements and minus depreciation.
You might need to recapture the depreciation if a property sells for more than its depreciated value. Meaning the amount of depreciation will be included in your taxable income from the sale of the property.
Since the size of the depreciation recaptured increases with time, it may be attractive to do a 1031 exchange to avoid the sizeable increase in taxable income that depreciation recapture would cause later on. Depreciation recapture will be a factor to take into consideration when calculating the value of any 1031 exchange transaction.
What are the Timing and Rules When Choosing a Replacement Property?
Like-kind property is defined according to its nature or characteristics, not its quality, meaning there is a broad range of exchangeable real properties. Industrial property can be exchanged for a commercial building, for example, or vacant land can be exchanged for residential. But you can’t exchange real estate for jewelry, for example, since that does not meet the definition of like-kind. The property must be held for investment though, it cannot be resale or personal use and this usually carries a minimum of two years’ ownership.
Your replacement property should be of equal or greater value to realize the full benefit of a 1031 exchange. You have to specify a replacement property for the assets sold within 45 days and then complete the exchange within 180 days. There are three rules that can be applied to define identification and you have to meet one of the following:
- Three-property rule – this lets you identify three properties as potential purchases regardless of their market value.
- The 200% rule – this lets you identify unlimited replacement properties as long as their cumulative value does not go over 200% of the value of the property sold.
- The 95% rule – this allows you to identify as many properties as you like as long as you obtain properties valued at 95% of their total or more.
What are the Different Kinds of Like-Kind Exchanges?
There are several possibilities for making 1031 exchanges that vary in their timing and other details, each creating a set of requirements and procedures that have to be followed:
- 1031 exchanges that are done within 180 days are commonly referred to as delayed exchanges, because at one time, exchanges had to be performed simultaneously.
- Build-to-suit exchanges let the replacement property in a 1031 exchange to be improved or newly constructed. However, these types of exchanges are still subject to the 180-day time rule, meaning all renovations and construction must be finished by the time the transaction is complete. Any improvements made after this time period are considered personal property and won’t qualify as part of the exchange.
- A reverse exchange happens if you acquire the replacement property before selling the property to be exchanged. In this case, the property must be transferred to an exchange accommodation titleholder (this can be the qualified intermediary) and a qualified exchange accommodation agreement must be signed. Within 45 days of the transfer of the property, a property for exchange must be specified, and the transaction must be carried out within 180 days.