In the real estate arena, a 1031 exchange means you swap your investment property for another one. This allows the seller to defer capital gains. The term gets its name from the IRS code Section 1031, which is used commonly by title companies, realtors, and investors. A few people even insist on turning it into a verb, as in: “Let’s 1031 that land for another”.
IRS Section 1031 has many parts that sellers should understand before trying to use it. Properties used in a 1031 must be similar. Additionally, IRS rules limit use with vacation properties. There are even tax implications and time frames that might prove to be problematic.
Nonetheless, if you are still considering 1031, or are just curious, here is what you should know about the rules.
What is Section 1031?
Broadly speaking, a 1031 exchange is a swap of one investment property for another. You may have heard it referred to as a like-kind exchange or a Starker. Essentially, if your property meets the requirements of 1031, you will have no tax or limited tax due during the time of the exchange.
In effect, you also have the option to change the form of your investment without cashing out or paying a capital gain. This will also allow your investment to continue growing tax-deferred.
There is no limit on how often or how frequently you can do 1031. In fact, you can rollover the gain from one piece of investment to another, and then again to another, and another. While you might earn a profit on each swap, you will be able to put off paying tax until you sell for cash later down the road.
Then, if things go as planned, you will only pay one tax. That tax will also be at a long-term capital gains rate. (Currently 15% or 20% based on incomes—and 0% for some lower-income taxpayers.)
A majority of the exchanges should merely be of “like-kind.” This is a puzzling phrase that doesn’t mean what you think it actually means. You can swap an apartment building for a block of raw land or a ranch for a strip mall. The rules are pretty liberal—you can exchange one business for another. However, you should know that there will be traps for the unwary.
The 1031 provision is for business and investment property. However, the rules do apply to a former primary residence under specific conditions. There are even other ways you can use 1031 to swap properties—but the loophole, in this case, is much narrower.
Why Does a Buyer Choose to do a 1031 Exchange?
When someone sells a property, they are generally required to pay capital gains tax on the amount that the property has appreciated. For instance, let’s say an individual purchases a block of land for $400,000 and sell it for $8,00,000. They will pay capital gains tax on that $400,000 increase.
On the other hand, when they enter into a 1031 exchange, they will be able to postpone the capital gains tax. The federal government allows investors to defer capital gains tax if they put the proceeds from the sale directly into another property.
According to the IRS, the second property must be “like-kind.” This means that is must be used for productive use in a trade, investment, or business. It cannot be the investor’s personal residence.
Furthermore, the investor only gets 45 days to determine whether a specific property is the one they wish to purchase. This does not give the buyer much time. From there, the buyer will have 180 days to close on your property. Things have to move quickly.
How Will the 1031 Exchange Affect the Seller?
First and foremost, you should write in your contract that there won’t be any additional cost for you to work with a buyer in the 1031 exchange. It is also vital to note that when your buyer sells their original property, they won’t be allowed to hold the funds. These funds are referred to as ‘proceeds’ that they will use to purchase your home.
Though it is technically the buyer’s money, it is mandatory that they hire a third-party agent, aka a qualified intermediary, to hold the funds. When it is time for the buyer to purchase your property, the qualified intermediary will transfer the funds to you. Then its time to close the sale. Being a seller, your contract should include language that acknowledges the following.
- You are aware of the buyer’s intention to complete a 1031 exchange
- You agree to cooperate with the buyer at no additional cost or liability to you
- And you are aware that the buyer has assigned certain rights to the qualified intermediary.
As the Seller, can You do a 1031 Exchange?
When you work with a buyer in a 1031 exchange, you might find yourself wondering if you have the choice to enter into a 1031 exchange as well. If you wish to do a 1031 exchange, the property you plan to buy should be used for productive use in an investment, business, or trade. Again, it cannot be a personal residence. You should also hire a qualified intermediary to hold the funds for your exchange. You will want to be working with a qualified land specialist to be sure you dotting all the “i’s”.
As stated above, the deadline within which a 1031 exchange must happen is quite small and strict. Within the short time frame of 45 days, you should identify the property you plan to buy. You will then need to close on the property within six months.
On a positive note, you will be able to defer capital gains tax, as well as some of any depreciation recapture tax liability. This is because there is no limit to the number of 1031 exchanges you can perform. Under the current federal estate tax law, you can hold gains indefinitely in the event that the property is passed down to your heirs. They then receive a stepped-up cost basis. This will negate a liability on years of capital gains.
The Bottom Line
If you are a savvy real estate investor, you can use the 1031 exchange as a tax-deferred strategy to build wealth. The various, complex moving parts not only require that you understand the rules, but you also enlist professional help-even for seasoned investors.
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