What is a 1031 (Tax-Deferred) Property Exchange?
Section 1031 of the U.S. Internal Revenue Code allows investors to defer capital gains taxes on the exchange of like-kind properties. Defer is the key word here. A 1031 exchange is a method for deferring capital gains tax on a real estate transaction. 1031 exchanges (or tax-deferred exchanges) hold great advantages for all types of real estate investors.
An Excellent Tax Loophole
Like-kind exchanges are truly one of the best tax loopholes for the average investor. The catch? You have to keep trading up on property values to avoid taxation. For example, if you bought a property that cost $100,000 and it has increased in value to $250,000, you have a $150,000 gain if you sell it. If you exchange it for another property worth $100,000, the entire $150,000 in gain will be taxable.
So the real tax benefit kicks in when you swap one investment property for another. While there are specific guidelines that cover each type of transaction, there are some general rules that must be followed:
- The exchange must be “like-in-kind.” Application of this standard can be surprisingly liberal. An experienced real estate lawyer can help you negotiate the statutory rules here.
- If the replacement property is identified and available and the owner wishes to acquire your property, the exchange may be a simultaneous swap of the relinquished property for the replacement property.
- If the replacement property is not identified/available at the time you sell the relinquished property, you can sell your relinquished property now and acquire your replacement property within 180 days. The sale proceeds from the relinquished property must be held by a third party until used to buy the replacement property.
- Within 45 days of the sale of your relinquished property, you must designate to the intermediary, in writing, the replacement property you wish to acquire. You then have 135 days to close.
What Exactly Are The Tax Advantages In Exchanging?
You can eliminate paying any capital gains taxes, and you can eliminate paying the even higher rate taxes on the recapture of depreciation you've taken on your property. By exchanging into a higher priced property you'll also gain additional depreciation deductions which can increase your after tax income.
Can I Avoid Paying Taxes Forever?
Yes, you can. By simply following the 1031 exchange rules every time you sell one or more properties and buy replacement properties, when you die your estate escapes all the capital gains taxes forever!
How long can I take to buy a new property?
You have 180 days between the closing date on the sold property and the closing date on the purchased property.
Can I Buy A New Property Before Selling My Old One?
Yes, you can buy a new property before selling the old property and still qualify it's called a "reverse" exchange. A qualified intermediary takes title to the new property you buy and holds it for you until you sell your old property.
Can I Get Money Out Of The Exchange Tax Free?
Yes, one way is to complete the exchange first and then refinance the new property.
Can I Buy More Than One Piece Of Property Tax Free?
Yes, you can acquire any number of replacement properties.
Can I Exchange Several Smaller Properties For A Larger One?
Yes, you can sell any number of smaller properties and trade up to a larger one.
How Do I Exchange Into A Larger Property (Trade Up)?
You trade up by getting a bigger loan on the new property, or adding cash, or equities in other properties, or notes carried back from the sale of other properties, etc. Done right, it's all tax free.
Are There Reasons To Exchange Other Than Tax Advantages?
Yes, there are many nontax reasons to exchange. For example, if you no longer like managing property, you can exchange your management intensive property for a management free property, or exchange multiple smaller properties for one that can be professionally managed. Or, say your current property cannot be easily refinanced. You could exchange out of that property for a new property which could be refinanced more easily so you can take some cash out. Or, you might exchange to improve cash flow.
How Can I Qualify To Defer My Taxes When I Sell My Property?
Any investor can qualify! Section 1031 of the IRS code lets you sell your property and buy a new property and deferring the payment of taxes owed. You simply follow specific rules. A qualified intermediary can help you qualify and gain the advantages of a 1031 tax free exchange.
What Kind Of Real Estate Qualifies For A 1031 Exchange?
Almost every kind of real estate is considered "like kind" and can be exchanged for any other real estate, including vacant land for apartments, a rental house for a shopping center, an office building for a leasehold interest with 30 years or more remaining, as long as you hold them for investment or business use.
Can I Use My IRA In Conjunction With A 1031 Exchange?
Yes, if you do it right. Using an IRA for real estate requires a special Self Directed IRA. Your Self Directed IRA at Charles Schwab or Fidelity does NOT permit you to hold real estate or any asset other than securities. This can be solved by moving your IRA to a custodian that allows for real estate in the plan document. With the right Self Directed IRA (known as Real Estate IRA) and proper structuring, you partner with your IRA to buy leveraged real estate. When it comes time to sell, you can 1031 your portion of the gain while the IRA gets its portion of the gains tax exempt.
What Is A Qualified Intermediary?
The IRS says if you touch the money you pay the tax. However, if you use a qualified intermediary to transfer the money from the sold property into the purchased property, you qualify for a tax free exchange. The IRS does not permit your accountant, attorney, or escrow company to be your intermediary. Qualified intermediaries are members of the Federation of Exchange Accommodators and are bonded.
Can I Get Legal Or Tax Advice From An Intermediary?
No, the IRS doesn't allow a person to act as both your qualified intermediary and your attorney or tax advisor. So work with your attorney and CPA to make sure your tax free exchange goes smoothly.
Can I Refinance Without Blowing The Tax Free Exchange?
Yes, you can refinance the property you are selling before you exchange, or refinance the property you are buying after you exchange, and the proceeds are taxfree. Check for the details as the timing and contract dates are critical.
Can I Carry Back a Loan on the Property I'm Selling & Still Have A Tax Free Exchange?
Yes, the payments you receive are taxed as you get them, on an installment sale basis. The balance of your equity is exchanged tax free.
I Have Already Sold My Property. Can I Still Do An Exchange?
Yes, provided your sale has not closed yet, your taxable sale can be turned into a tax free exchange with some simple paperwork.
The information on this page is meant to provide a general overview of the law. The laws in your state and/or city may deviate significantly from those described here. If you have specific questions related to your situation you should speak with a local attorney.
Related Topics In This Section
- Real Estate
- Buying a Home
- Loan Workout
- Mortgage Refinancing
- Real Estate Condemnation
- Landlord Tenant Law