What's a 1031 exchange, and how to do it correctly
A 1031 exchange is a tax strategy which is responsible for helping investors sell a property in exchange for another property. It allows an investor to defer capital gains from the first property’s sale. It’s great for investors who want to purchase more real estate, rather than cashing out and paying taxes. Let’s be clear – it’s a way to avoid paying immediate capital gain taxes. There are plenty of pitfalls and consequences you have to consider before engaging in this strategy. If you do the 1031 exchange wrong – you’ll have to pay taxes on the property’s sale.
This article should help highlight what to look for so you can avoid any mistakes when conducting your 1031 exchange.
What’s your goal?
1031 exchanges aren’t for everyone. If you capital quick, then look elsewhere. 1031 exchanges require you to exchange 1 property for another, so you won’t cash out. It’s better to create an investment plan so you can plan out your long term goals. It’ll help you create a framework, and understand which properties to look for when doing a 1031 exchange. It’ll also help you budget out how newer properties can provide greater returns over time for you and your business. Bottom line, without an investment plan in place – looking at a 1031 exchange can be a waste of time. You really need to know exactly WHY you’re doing it, and how it fits into your macro strategy.
If your goal is to take out capital right now, then it might make sense to pay taxes now. If your goal is to think long term, then a 1031 is great since you can stall taxes and continue creating investments that payout in the future.
Figuring out what property qualifies for 1031 exchanges
According to the IRS, you can only exchange “like-kind,” properties. That’s a very flexible, yet firm, definition, The IRS says the properties have to be similar enough in order to qualify as like kind. They say quality or grade, of the property doesn’t matter. A vacation rental home, built on a plot of land, is like-kind to a vacant plot of land.
Another issue to consider is ownership of the property. You have to own the property for it to qualify for a 1031. A joint ownership of property via a fund, or a REIT, won’t qualify. Joint venture ownership of a property may not qualify either, depending on how the venture was structured. Typically, before you buy a property – you should think about how you’ll “exit.” That way you can setup the appropriate legal and financial structure when buying it.
Learn about the restrictions
There are many restrictions you need to consider. Knowing them will help you from potentially violating 1031 exchange rules. One major restriction is that these exchanges only work for investment properties, not personal ones. The property must be in the USA. While there’s no restrictions on property price, you still want to pay attention to this. If you exchange your property for a cheaper one, the difference may be taxed.
Understanding how the 1031 exchange is structured
Some 1031 exchanges happen immediately. That means both properties are sold simultaneously. It’s really difficult. It requires you to find the right property, and execute the sale at the same time as you sell yours. It’s very difficult, and rare. This is why most people engage in “deferred,” exchanges. It means you sell your property to an intermediary, who is then buying the property on the other side of the exchange. It makes sure that the entire series of transactions are considered one transaction. It prevents you from receiving taxable cash from the sale of the initial property.
Here’s what the IRS has said, “taxpayers engaging in differed exchanges generally use exchange facilitators under exchange agreement.” This is because everyone knows the restrictions on the type of intermediary you can use. You can’t use someone who works for you, for example. The party has to be a CPA, or attorney, who specializes in these exchanges. You have to remember – the entire exchange can be voided by the IRS if any rule is not followed.
Time is of the essence
Once you have both properties lined up, you have to move fast. You have 45 days from the date you sell the property to identify the property you want to buy. This has to be written down by someone involved in the transaction. Investors usually identify three properties, so they have a backup plan if the initial property fails. You have 180 days to complete the exchange from the initial sale.
Report the 1031 exchange to the IRS
Once you complete both sides of the transaction, you have to report the 1031 exchange to the IRS using form 8824 in the same year it occurs. According to the IRS, this form asks for things like descriptions of the property, the value, the gain, and loss, and cash received, and lots more information. After it’s filed, your 1031 exchange is successful. You’ve got less taxes, and hopefully a bigger real estate empire now.