Wouldn’t it be great if there was a way to sell your current real estate investments and defer capital gains taxes indefinitely?
Actually, there is.
Savvy investors can use 1031 exchanges to save on taxes by “swapping” one property for another. The method gets its name from Section 1031 of the Internal Revenue Code and is sometimes also known as a like-kind exchange or a Starker exchange.
How Do 1031 Exchanges Work?
While the essential concept is simple, 1031 exchanges can get complicated quickly, so it pays to understand the ins and outs—and work with a professional tax expert—before you dive in.
Typically, when you sell a piece of real estate, you need to pay taxes on the capital gains for the tax year in which it was sold. Section 1031 gives sellers a limited amount of time to use the proceeds from the sale of one property (the “relinquished” property) to buy another property (the “replacement” property) and defer paying the capital gains taxes on the relinquished property until the replacement property is sold—even if that is years in the future.
Since long-term capital gains taxes typically run 15% to 20%, this can add up to a sizable sum that can be invested elsewhere. Moreover, investors can keep 1031 exchanges going indefinitely, exchanging their replacement property for another, and then another, and continuing to defer taxes until the last property is sold outright.
The 1031 provision is aimed at business and investment property. You cannot exchange residential or vacation homes unless they have first been converted to rental properties.
Section 1031 Requirements: The Fine Print
Following are some of the most notable requirements that investors need to be aware of when using 1031 exchanges. The exact requirement will differ from one situation to the next, however, so it’s important to work with experts who can guide you through the process and ensure you’re getting the most value from your exchange.
The 1031 rules state that relinquished properties must be exchanged for “like-kind” replacement properties. Fortunately, the definition of “like-kind” gives you broad latitude to exchange virtually any type of business or investment property, including:
- Unimproved land
- Single and multi-family rental units
- Commercial buildings (offices, shops, etc.)
- Industrial facilities
- Storage facilities
Residential properties, properties outside the United States, and securities such as REITs or real estate funds, do not fall under the 1031 exchange rules and are not considered like-kind.
The 1031 rules give you 45 days from the sale of your relinquished property to identify up to three possible “like-kind” replacement properties, and up to either 180 days or by the due date (with extensions) of your tax return, whichever is earlier, to acquire one of them.
Failure to identify and acquire a replacement property within these timeframes will result in being taxed on capital gains as you would from a regular sale.
1031 exchanges are rarely a perfect one-to-one match, so you may still have taxable gains or losses for the year if you give or receive cash, property, or value, such as a reduction in mortgage, or if you’ve previously claimed a depreciation on the relinquished property.
Taxable amounts that cannot be deferred are known as “boot,” and are most often triggered when the seller trades down in either total value or equity.
Tax Deferred, Not Tax-free
Bear in mind that 1031 exchanges let you defer taxes, in some cases indefinitely if you continue to exchange properties using the 1031 system. However, you will need to pay taxes on the capital gains from any outright sales.
An exception is that if you die before selling a property, your heirs will inherit it on a “stepped-up” basis, meaning that its value will be based on the current market and the tax deferment wiped out. If you’re planning to leave the property in your will, it’s worth consulting an estate planner to ensure that you and your heirs can take full advantage of the tax benefits.
By the rules of the 1031 exchange, the seller may not hold the funds from their relinquished property until they have acquired the replacement property. That means working with a qualified intermediary, known as an exchange facilitator, who will sell your relinquished property, buy your replacement property, and hold your funds in escrow for you until the exchange is complete, at which point they’ll transfer both the deed and the money to you.
While Tonneson + Co does not act as an exchange facilitator in these cases, we are happy to refer interested investors to qualified intermediaries.
Types of 1031 Exchanges
Although all 1031 exchanges work on the same essential principles, there are several possible ways they can be structured. The rules for each are a little different so, again, be sure to work with both an exchange facilitator and a qualified tax advisor to be sure you don’t lose any benefits.
You sell the relinquished property first and have 180 days to close on the replacement property.
You buy your replacement property first and have 180 days to sell the relinquished property.
You buy and sell your exchanged properties on the same day.
These allow you to use your deferred tax dollars towards renovations or building on the replacement property. The improvements must be completed within the 180-day period.
Is a 1031 Exchange Right for You?
Done correctly, 1031 exchanges are a powerful way to build wealth—but mistakes can be costly. It pays to work with a qualified tax advisor to ensure that you’re filing your exchange appropriately with the IRS, that you are taking full advantage of what the 1031 exchange has to offer, and that you stay abreast of any changes to tax law that could affect current and future transactions.
If you’re interested in working with Tonneson + Co, please reach out to us. We look forward to hearing from you!