What Investors Need To Know About 1031 Exchanges

What Investors Need To Know About 1031 Exchanges

Do you want to diversify your portfolio through real estate investments? Do you want to sell your old property for a new one? If so, there’s one tool real estate investors like you should understand—the 1031 exchange.

The 1031 exchange is an underrated investment tool that helps real estate investors maximize their profit and build wealth. How? It defers capital gains taxes upon the sale of an investment, allowing investors to diversify their portfolio by reinvesting in other properties.

However, taking advantage of this tool is a complicated process. Hence, you may consider getting professional help from financial experts like Peregrine Private Capital. They’ll guide you through the process to secure your earnings and manage your investments.

But before you do so, it’d be best to understand what the 1031 exchange is all about. If you don’t know where to start, then this page may help. In this article, you’ll discover everything an investor like you should know about the 1031 exchange.  

What Is A 1031 Exchange?

As the name implies, a 1031 exchange is the process of exchanging one real estate property for another while deferring capital gains taxes. In other words, it allows investors to buy and sell real estate investments without immediate tax obligations.

Its name was coined after Section 1031 of the United States Internal Revenue Code (IRC), which was developed in 1921 to encourage investors to reinvest periodically. But remember that there are rules to follow, and not everyone may be eligible for the exchange.  

What Lies Deep Inside IRC Section 1031?

IRC Section 1031 provides that a real estate investor can delay the payment of capital gains taxes upon the sale of a real estate property for a certain amount of time. It will take effect once the investor complies with all the requirements stated in the said section.

To comply with the requirements, you must ensure all investment swaps are like-kind. Like-kind means two investments sharing similar attributes and nature. The criteria of becoming like investments aren’t measured through innate quality or stated value.

For example, you can exchange vacant land for a commercial building or a manufacturing plant for a residential townhouse. However, you can’t swap a residential property for a piece of artwork, even if both have the same value and quality.

On top of that, the property to be exchanged must be a pure investment product. It shouldn’t be declared for personal or reselling use. And it should have ownership for at least two years.

The rules of Section 1031 may encompass a wide range of exchangeable real estate properties. But keep in mind that there might be traps along the process, so be wary as much as possible and don’t be swayed by your excitement.

Why Does Depreciation Matters To 1031 Exchange?

Depreciation refers to how the value of a specific investment gets shaved off every year. For example, if the value of your property today is around USD$1.5 million, next year, its value will depreciate to USD$1.45 million, depending on the case of wear and tear.

If you exchange a depreciable property or swap a property at a price higher than its depreciated value, an effect known as depreciation recapture will be triggered. Depreciation recapture is a profit to be taxed as a part of your ordinary income.

This is one of the aspects that makes the 1031 exchange a complicated process. This is why it’s highly recommended to consult financial professionals to help you understand how the process works.

What Changes Have Been Made To The 1031 Exchange?

What Changes Have Been Made To The 1031 Exchange

The 1031 exchange previously allowed other products of investments to be swapped for real estate properties. For example, in the past, you could exchange your commercial building for an expensive piece of artwork, a business license, or equipment.

However, the rules of the 1031 exchange changed when the Tax Cuts and Job Act (TCJA) was passed into law in December 2017. Now, only real estate property will qualify for 1031 exchange according to the amended Section 1031.

What Are The 1031 Exchange Timing Rules? 

Decades ago, exchanging investments was executed between two mutual investors. However, the chances of finding an investor with the property you want and who wants to have your property are slim to none. This is why most exchanges today are delayed or three-party. 

Delayed exchanges use a mediator who will manage your money upon the sale of your property and find the perfect property for reinvestment. That middleman is also known as a qualified intermediary.

In delayed exchanges, two timing rules have to be observed. These are 45-day and 180-day rules.

  • The 45-Day Rule

After selling your property, the middleman will take the payment on your behalf. You can’t touch it, or the exchange won’t take place. This will start the 45-day countdown. Within 45 days, you should be able to identify the property you want to acquire for your reinvestment. 

There are rules to follow when identifying your replacement property which will be discussed later. Once the chosen property has been identified, notify your intermediary in writing.

  • The 180-Day Rule

This rule will commence after you have informed your middleman about the replacement property you want to acquire. Within 180 days, that property has to be purchased, or the 1031 exchange won’t occur. The middleman will transfer the payment to the seller of the property.

It’s worth noting, however, that both 45-day and 180-day timing rules may occur simultaneously. For example, if it takes 30 days to identify your replacement property, you only have 150 days to complete the purchase.

Here’s a summary of the timeline of the entire 1031 exchange:

  • The sale of the property commences.
  • The intermediary receives the money once the property has been declared sold.
  • Within 45 days, you must find a replacement property and inform the middleman in writing.
  • Within 180 days, the purchase of the replacement property has to be completed. The intermediary transfers the money to the seller of that property.

What Are The Rules To Follow When Identifying A Replacement Property?

As mentioned earlier, there are rules to follow when selecting a replacement property. These are the 95% rule, 200% rule, and three-property rule.

  • The 95% Rule: This rule will allow you to identify as many properties as you want. However, you must purchase the one with 95% of their total value.
  • The 200% Rule: This rule allows you to designate as many properties as you want as long as their accumulated value is less than 200% of the value of your property.
  • The Three-Property Rule: This allows you to choose between three properties regardless of how much they cost. However, specific valuation tests will take place if you plan to select more than three.

The rules can be complicated, so consider asking financial professionals for advice and proper guidance.

What Is Reverse 1031 Exchange?

Is it possible to acquire the replacement property without selling the old one and still comply with the rules stated in IRC Section 1031? Yes, that situation is possible. This process is known as reverse 1031 exchange.

In reverse 1031 exchange, the same 45-day and 180-day timing rules apply. However, the process starts with the purchase of the replacement property and ends with the completion of the sale of the old one within 180 days. 

Also, instead of identifying which property to purchase, you determine which property of yours to put for sale. The identification process also commences after the purchase of the replacement property and must be completed within 45 days.

What Is Boot, And Why Should You Avoid It?

If the replacement property is valued lower than the property you sold, you may still have leftover funds. This leftover cash is called ‘boot’ and will be returned to you after the 180-day period. Also, this cash boot is taxable as partial sales proceeds—in other words, capital gains.

Cash boot also applies to mortgaged properties. For example, if the old property is mortgaged at USD$1 million and the new property is mortgaged at USD$900,000, the USD$100,000 difference will be considered boot and taxed.

Below are other expenses and fees that may affect and lower the value of the taxable boot. You can use the leftover exchange funds as payment for the following: 

  • Escrow fees
  • Finder’s fees
  • Qualified intermediary fees
  • Tax adviser fees
  • Attorney’s fees
  • Broker’s commission
  • Filing fees
  • Premiums on title insurance

On the other hand, here are fees that can’t be settled using the leftover funds. Hence, there’s no impact on the taxable boot.

  • Insurance premiums
  • Financing fees
  • Costs of repairing or maintaining the property
  • Property taxes

What Does 1031 Exchange Mean In Estate Planning?

The most challenging part of the 1031 exchange is probably when the time comes that you need to settle your tax deferrals. You’ll certainly be surprised at how big your bills are, but there’s one way to avoid paying your delayed taxes.

Tax obligations, including tax deferrals, end with death. When you die, your heirs or loved ones won’t be forced to settle your outstanding tax liabilities. This is why it’s a good idea to consider the 1031 exchange when establishing a comprehensive estate plan.

Final Words

The 1031 exchange is an excellent tool for real estate investors willing to diversify their portfolios and maximize their income potential. However, you must follow many rules, making the process even more complicated. That being the case, you should consider consulting financial professionals to understand better how 1031 works.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.