The use of 1031 exchanges has increased its popularity during the Covid-19 pandemics, providing multiple sales across many real estate asset classes.
The deals procured through the use of 1031 exchange rules allow sellers to avoid paying taxes on capital gains by reinvesting sales within a specific time frame, or through a reverse transaction where one property is acquired and a different one is sold.
Navigating deadlines, we have seen a significant amount of 1031 activity on the exchange market. Following the 1031 exchange rules, a buyer usually has a 45-day time frame to identify the replacement property, and then another 180 days to close the deal to secure the taxing privileges.
With Covid-19, however, the deadlines to identify a replacement property and to close the deal were extended for almost a year, but the 1031 Section has many interchangeable parts that real estate investors must be aware of and understand before venturing into the application.
A 1031 tax-deferred exchange can only be made with like-kind properties and 1031 exchange rules are there to limit the wrongful use of properties.
These new (but even the older ones) tax implications and time frames may be also problematic, but if you’re considering a 1031 exchange real estate – here is what you need to know about the 1031 exchange rules.
First of all – what is a 1031 exchange?
1031 exchange rules state that a tax-deferred exchange is a transaction where a taxpayer (buyer) can sell one property and then buy another – without a tax consequence.
The 1031 exchange is generally done to avoid paying taxes on large capital gains and taxes on the sale of appreciated property and/or the property that has been substantially depreciated for tax purposes, usually over several years.
Therefore, the 1031 tax exchange has a very weak tax basis. When you sell one property, you usually have to pay tax on the procured gains. Section 1031 of the Internal Revenue Code allows you, as a taxpayer, to defer the tax due on the sale of property held for investment or used in business (or trade) purposes if the sold property is exchanged for another “like-kind” investment.
This 1031 exchange process provides an opportunity to preserve and grow companies but the most significant phases to understand signify the need for:
- Relinquished Property: The existing investment/property that you are selling
- Replacement Property: The property you will proceed to acquire with selling your surrendered asset
- Qualified Intermediary (QI): The designation of a “middle man” who will be holding the proceeds from your property on sale. The QI transfers the funds to close the sale on your new (replacement) property.
- Like-Kind Property: to qualify for a 1031 exchange, your future property needs to be similar (and use) to the one you plan on selling. Your replacement property must be for investment, and can not be part of the resale or for personal use. For example, exchanging vacant land for a commercial building, or exchanging industrial property for residential property is not possible.
Why do you need a qualified intermediary?
A qualified intermediary in a 1031 exchange is defined as a “safe harbor” that helps to establish the boundaries for exchanges. As long as your transaction is structured within the agreed boundaries, it is okay to presume that your exchange will be allowed.
Can you identify the property on your own?
The replacement property must be identified and provided in a written form to the qualified intermediary by the end of the 45th day. This property must be identified with specificity: address, tax map, and parcel number, unit number, etc.
A 1031 exchange agreement is a contract drawn between the qualified intermediary and you. The contract outlines the duties and obligations of both parties and sets out the conditions under which your interests can be delivered to you.
How does a 1031 tax-deferred exchange work?
You should always be able to discuss the applicability of a 1031 Exchange with your real estate and tax advisor – before transferring the property you are selling and before settling for your qualified intermediary (QI).
Your QI is there to provide the required exchange agreement and other important documentation that needs to be impeccable before you assign your property to another.
A few words about 1031 exchange advantages
There are many advantages to a 1031 Exchange, whether you are an individual with only one rental house, corporation, or a shopping center. The primary 1031 exchange rules say that you can sell the property without incurring any immediate tax liability.
You may afterward use a 1031 tax-deferred exchange to proceed and invest in another project. That will keep the money you would have spent on taxes working for you.
How must the 1031 exchange be structured to avoid immediate tax?
For the deal in 1031 exchange to avoid paying any capital gains tax, you need to reinvest all that proceeds from the sale of your property until the purchase of the new property of equal or greater value.
You must be sure that you have replaced any existing debts with an equal (or greater) amount of debt. Any not reinvested deeds in the replacement property and/or any debt relief will be taxed.
How does a reverse exchange work?
A reverse exchange is a deal when you acquire replacement property before you succeed to sell your initial property. Although it’s not the preferred 1031 exchange structure, these “reversed” circumstances can be accepted through special measures.
When you eventually sell the replacement property, rather than completing another 1031 Exchange, you will be obligated to pay capital gains tax on the replacement asset.
Are there any disadvantages in 1031 Exchange real estate deals?
As with any other deal, you might face real estate selling and/or buying, there are disadvantages in the 1031 tax exchange. To be precise, there are three primary disadvantages.
You may not use any of the profit from the sale of your property for anything except investing in a replacement asset without tax consequences.
When you find the property that you wish to buy but you have a change of heart after 45 days, your qualified intermediary (QI) must hold the proceeds until the 181st day.
Returning the funds before the day of completion would be a disbursement to the 1031 tax exchange agreement enrolled between you and your QI.
You will have to reduce the basis of your replacement property, which can result in the carry-over basis of the property you sell. If you eventually sell the replacement property, you will obtain more gain than if you had acquired the property through a direct sale and purchase.
What qualifies as a 1031 exchange property, and what doesn’t?
Residences or a second home do not qualify as useful in the 1031 exchange property. You may not exchange your residence or second home, nor may you acquire these types of assets as your replacement property either.
You could “convert” your second home to valid exchange property and establish the intent by properly renting it and making it a legitimate rental property.
Consultation with a CRE advisor is important if you wish to change how you want to hold your property.
Assets that are primarily for sale are prevented from qualifying for 1031 Exchange treatment. Most properties owned by developers, builders, and people who perform restoration kinds of works are held primarily for sale and may not be subjected to an exchange.
When these properties are sold, they are usually subject to ordinary income taxes, rather than large capital gain charges.
Our role in the 1031 Exchange
The professionals at IPG are licensed legal, tax (finance), and logistics representatives specializing in 1031 exchanges. Using our tax background, investment experience, and commercial real estate expertise, we investigate each Exchange program and sponsorship.
Clients can expect sophisticated, discerning, and selective standards when analyzing and researching programs, variables, and assist investors in making an informed decision on their replacement property.
IPG will work with you, answering questions and doing analysis to assure you are investing in the replacement real estate that best suits your needs and benefits your ownership.
Our levels of understanding, procedures reviewing, and property comparisons are unique in the industry, making us an experienced and trusted source for answers to your 1031 questions.