Buy low and sell high, is the common goal for most investors. In this bull real estate market run that we’re currently on, many investors are considering cashing out their winnings and possibly reinvest in more real estate. Especially, if you purchased your real estate investment during the last crash, you may be sitting on significant gains along with significant taxes waiting on those gains. So, how can you sell and at the same time keep as much of the profits to re-deploy into your next investment? Using the IRS tax code 1031, this allows you to defer taxes on gains from the sale of an investment property as long as you’re doing a “like-kind” exchange. I’ll explain what that means later, but as with anything related to the tax code, a 1031 exchange has many requirements that must be met along with a specific series of events to all be completed within a strict timeline. The first thing to check is, does your transaction qualify and a few key items you need to understand about a 1031 exchange to determine if it’s right for you.
First, a 1031 exchange only defers the taxes that you would have owed on the profits from the sale of your investment property, it is not intended to completely avoid them. This means that you are essentially kicking the tax can down the road to be paid at a future date. Which can be beneficial as “future” money could be worth less than the current buying power available. There is a strategy that if you continuously use the 1031 exchange for each consecutive purchase, you would be able to keep kicking that tax can down the road. It’s been said that if you were to die, you can escape the requirement to pay back the deferred 1031 taxes on all your previous exchanges. However, you may want to check with your CPA on this one, as I am not a CPA, I can’t confirm this. Second, you must fulfill the like-kind exchange requirement. This means the like-kind replacement must be exchanging real property for real property, it can’t be stocks, artwork, etc. In addition, a 1031 exchange also only applies to an investment property, you cannot utilize this for an owner-occupied property. Likewise, the replacement property must also be an investment property. Third, in order to defer all of your gains, your like-kind exchange property must have a value either equal to or greater than the property you are selling. It is possible to trade from a single family up to a 2-4 unit property or even commercial property and vice versa as long as the exchange values line up. If the property you’re exchanging for is less in value than the one you sold, you will be taxed on the unused remaining profit. Alternatively, it is possible to trade your 1 property for 2 properties that are individually lower in value, but when combined are equal or greater in value of the property you are selling. Fourth, to utilize a 1031 it must be the same named individual(s) or entity that is selling and buying. If the property is owned by more than one individual, you cannot drop one name off, or add others on during any part of the 1031. In the eyes of the IRS, it must be the same party selling and then buying.
Now that you’ve determined that you qualify, let’s learn how to properly execute a 1031 exchange. The IRS says that you the seller cannot touch any of the profits from the sale of your investment property when doing a 1031 exchange. They require you to hire a 3rd party intermediary who will receive the profits from the sale of your property that you’re exchanging. This intermediary will hold your funds safely until you’re ready to close on the replacement property. Ideally, even before you list your property for sale, you’ll want to find an intermediary that specializes in 1031 exchanges to get yourself setup to arrange for the 1031 exchange process once your property has sold. There are some title companies that can offer this service as an intermediary to help streamline the entire sale of your current investment property and acquisition of your replacement property. The real fun behind a 1031 exchange begins once the property you’re exchanging has sold, there are very strict time limits and actions required that must be completed to successfully execute a 1031 exchange.
This clock starts ticking from the day that the property that you’re exchanging is sold, your profits will be automatically sent to your intermediary for safekeeping until you’re ready to close on your replacement property. You will have exactly 45 days from the date of closing on your sold property to “identify” at least 3 replacement properties. You are only allowed to purchase properties that have been officially identified through this process, of which you will have to notify your intermediary of these 3 properties. If you should change your mind, the identified property is sold before you can buy it, or your transaction falls through, then you can replace it with another property as long as you are still within this 45 day window to identify properties. The two key items are you can only purchase properties that you’ve officially identified and you only have 45 days to identify. Once those 45 days are over, you cannot identify any more properties no matter the circumstances. For the next item of order, you must close on your replacement property within 180 days from the date of closing on the property you sold. No extensions will be granted. These are the two major timeline items that you must be aware of and adhere to when performing a 1031 exchange.
If you’re able to complete all the steps outlined, then the potential benefits are that you’re able to defer up to 100% of the taxes that would have been due and apply 100% of your profits to acquiring your next investment property. In this market where properties are being sold quicker than you can identify, it can be more challenging to complete the entire exchange smoothly, so the key to your success is being prepared. However, if you’re an investor that prefers to take your time when looking for investment properties then a 1031 exchange may not be for you. There are lots of moving parts all at the same time, selling your current property, then finding your next property. So you may be better off just taking the tax hit on your profits, rather than feel rushed into acquiring your next property. Worst case scenario, if you fail to execute on your 1031 exchange, say you miss the deadlines, your funds that are being held by the intermediary will be released to you minus the cost to hire the intermediary. The cost of hiring an intermediary to complete a 1031 exchange, can be anywhere in the range of $700 to $1,500 or more. Now you know what a 1031 exchange is and how to execute one. One thing to note, it has been rumored that current President Biden will be making changes to 1031 tax code. Speculation is it will either be eliminated completely or possibly re-structured to have more requirements and restrictions. So you may want to do one before the law is changed and it’s too late. If those changes should occur, stay tuned for an updated blog post detailing those official changes.