If you are buying and selling investment property you may want to consider a “1031 exchange” to defer taxes. Here is an overview of this program-check with your CPA to see if it’s right for you!
What is it?
A 1031 Tax Deferred Exchange allows real estate investors to defer the payment of capital gains taxes when selling an investment property and exchanging into another investment property. There are several types of exchanges available to investors depending on how they wish to structure their transaction.
Like-kind exchanges — when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or “like-kind” – the IRS allows you to do a 1031 exchange (meaning you are not required to recognize a gain or loss at the time).
Definition of Like-Kind Property
Properties are of like-kind if they’re of the same nature or character, even if they differ in property type/price and can be improved or unimproved. It must be located in the US.
Types of Exchanges
Investors have the ability to structure their exchanges in several ways. Depending on the investor’s situation any of the four exchange types listed below could be a viable option:
*Simultaneous Exchange:
In a simultaneous exchange the relinquished property is sold and the replacement property acquired on the same day, with concurrent closings. The simultaneous exchange is rare and investors should still use an Exchange Accommodator when doing a simultaneous exchange.
*Delayed Exchange
The most common method of exchanging, the delayed exchange, allows investors to sell a property and then acquire replacement property within 180 days.
*Reverse Exchange
The reverse exchange allows investors to acquire replacement property prior to selling. The reverse exchange can be more complicated however, as investors cannot own both the new replacement property and (soon to be) relinquished property at the same time.
*Construction/Improvement Exchange
The construction exchange allows investors to use exchange proceeds to build on land or improve an existing property. The construction/improvements exchange is often used to acquire a ‘fixer’ and do improvements on the existing structure. The pitfall with a construction/improvement exchange lies in the fact that all exchange funds need to be spent on or before the 180th day of the exchange.
Step By Step
Here is a brief summary of the steps when doing an exchange:
- Set up an Exchange Account – The 1031 Exchange
account MUST be opened before close of escrow on the property being sold.
Contact a company that specializes in asset exchanges as you cannot hold the
proceeds from the sale of property (also called “asset exchange companies” or
“intermediary”).
- Insert the Appropriate Language
into the Sales Contract – A 1031 exchange has specific language that must be added
to the Purchase & Sale contract for the property being sold (usually by
executing a contract addendum signed by all parties).
- Complete the Exchange Agreement – At the close of
escrow, the asset exchange company will coordinate with the Title Company or
closing attorney to obtain all of the necessary signatures on all exchange
documentation.
- Locate Replacement Property – The most difficult
process of the exchange can often be finding the right replacement property
within the required timeframe. The
IRS requires that potential replacement property is identified on or before day
45 of the exchange and property must be acquired on or before day 180 of the
exchange.
- Submit 45 Day Identification
Letter – The Identification Letter
MUST be submitted no later than day 45 of the exchange. All potential
replacement properties must be identified in writing.
Realtor “To-Do” checklist:
An agent working with an investor conducting a 1031 exchange should make sure to perform the following four duties:
- Inform the client that 1031 Exchange is an option on ANY business or investment listing, or any owner occupied listing that has an investment component (house with a farm, house with an in-law unit in the back). However, be careful not to give tax or legal advice!
- Add the appropriate 1031 Exchange language to the Purchase and
Sale agreement prior to the contract being presented to the seller.
- Open an exchange account BEFORE the close of escrow. Contact a company that specializes in 1031 exchanges to handle the details, paperwork, and funds.
- Find a like-kind replacement property as soon as possible. Keep in mind your client is under a strict timeline to identify and acquire replacement property, so the sooner you start looking for property, the better.
Note: it is highly recommended Realtors obtain specific education on 1031 tax exchanges prior to representing buyers/sellers.
Frequently asked questions:
Q: How long do I have to own my property before I can exchange it?
A: The longer the better. Unfortunately, the IRS doesn’t specifically state a period for property to automatically qualify for an exchange (the property only need to be “held for investment” for it to be eligible for an exchange). Time of ownership is ONLY one factor at which the IRS looks at when determining if the property was “held for investment”. The general guideline is to hold the property for at least two years.
Q: Can I sell an investment home and purchase bare (unimproved) land?
A: Yes. Properties involved in an exchange need to be held for either use in trade or business or for investment. Holding land for its future appreciation is considered “held for investment”.
Q: Can I purchase my replacement property first?
A: Yes; this requires that you do a reverse exchange however. The reverse exchange ‘may’ be an option provided you have the ability to structure the reverse exchange according to the safe harbor guidelines. This is a more difficult transaction and requires expert guidance.
Q: Can I move into a rental that I originally bought as part of 1031 Exchange?
A: Yes. However keep in mind that the IRS will look at your “intent” in determining if your exchange was valid. If the IRS determines your original intention was to use it as a primary residence (when the property was initially purchased) the 1031 exchange may be disqualified. If you financed the property and the loan application states “owner occupied” (which has a lower interest rate versus a non-occupied home loan) the IRS could use that as proof your intention was not for investment.
Q: Do I have to reinvest ALL of my cash/equity?
A: No. However, any cash (equity) that is not reinvested in real estate will be taxable (this is called a “cash boot”). Basically if you personally “touch” the funds/proceeds you pay income taxes on it. That’s why an independent asset management company or intermediary is required.
Q: How long do I have to complete my exchange?
A: Maximum of 180 days to complete the entire process. You will be required to identify your potential replacement properties on day 45 of your exchange. Your timeline starts when you close escrow on the property you are selling.
Q: How do I report the exchange to the IRS?
A: When an exchange is completed you will report your exchange using Federal Form 8824 for the year your Relinquished Property was sold (IRS Form 8824). It is reported on Schedule D of your Federal tax return.
Always consult with your CPA, Attorney, or Financial Advisor for guidance on your specific situation and for changes/updates from the IRS (the rules can change at any time).
If you are considering financing a home for investment-with or without a 1031 tax exchange-please call Dyer Mortgage for assistance.
Sources: IRS, Asset Exchange Company, various industry publications and government agencies, CPA and Attorney/BAR association websites. Information deemed reliable but subject to change (effective March, 2019).