1031 Exchange: What is it and how does it work?

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If you are thinking about starting to invest in real estate, there is a way to sell off properties, reinvest in new properties and offset the tax liability.

There is a way to do this and it is known as a 1031 exchange. Also known as a “Starker exchange” or a “Like Kind exchange” – the 1031 exchange is defined under section 1031 of the IRS code.

This article will tell you about the 1031 exchange and how to use it.

So What Is A 1031 Exchange?

A 1031 exchange is a transaction that allows a taxpayer to defer the capital gains tax that would be due on a sale of an asset.

1031 exchanges are almost exclusively used in real estate. But they can be used for other types of assets as well.

Real estate investors can use a 1031 exchange to defer the capital gains tax on the sale of appreciated property if they reinvest the proceeds in a new property.

Sounds great right? Not so fast. While a 1031 exchange may sound simple, there are specific rules that must be followed to completely defer the capital gains tax.

History of the 1031 Exchange

The rules governing 1031 exchanges are provided in Section 1031 of the Internal Revenue Code and have actually been around since the twenties.

A traditional 1031 exchange involves a simultaneous swap of your property with a like-kind property. The rules governing traditional 1031 exchanges were complicated and the process to do the exchange was difficult.

In 1979, the famous Starker decision by the U.S. Court of Appeals changed the 1031 exchange. The Starker decision allowed a “deferred” exchange — selling your existing property first and then buying your replacement property.

It wasn’t until 1991 however, when the Treasury Regulations were amended to clarify and simplify the deferred exchange that this form of 1031 exchange became popular among real estate investors.

Therefore, when people talk about a 1031 exchange today, they are usually referring to a deferred – or Starker – exchange.

The General Rules of the 1031

A 1031 exchange is a tax-deferred exchange

If you complete a 1031 exchange, you can defer the capital gains taxes on the sale of your existing property.

However, if you later sell the replacement property, you will have to pay capital gains taxes (if you in fact have a capital gain). You may, of course, do a 1031 exchange with your replacement property and keep deferring your capital gains tax.

The property exchanged must be either held for investment or used in a trade or business.

Thus your personal residence does not qualify for 1031 exchange treatment unless it was used in your business.

The property exchanged must be like-kind property

The IRS is very liberal in defining like-kind property of real estate. Almost, any type of real estate, improved or unimproved, can be exchanged for other real estate.

The following types of properties are considered like-kind for 1031 exchange purposes:

  • A residential rental property and a commercial rental property
  • A shopping mall and an undeveloped piece of land
  • A condominium and a share of a cooperative
  • Permanent conservation easements in two different pieces of real estate
  • Water rights of unlimited duration and farmland

Certain types of property do not qualify for 1031 exchanges

These include

  • Property held for personal use
  • Inventory, partnership interests
  • Stocks and bonds

Vacation homes may qualify under certain circumstances.

The amount of capital gain that you defer will reduce the basis of your replacement property

Your depreciable basis of your replacement property will not equal the purchase price of the property. Your basis will be reduced by the amount of gain that is deferred.

Specific Rules Of The Deferred (Starker) Exchange

As we discussed above, a traditional 1031 exchange involves the simultaneous swap of your property for another property.

The deferred or Starker exchange allows you to sell your property first and then buy your replacement property later.

Specific rules must be followed to successfully complete a deferred exchange and defer all of the capital gains tax that would be due.

The Rules:

  • You must not have any access to the money from the sale of your property. The easiest and most effective way to accomplish this is by using a qualified intermediary (QI). You will sell your existing property and the money will go to the intermediary. The intermediary will hold the funds in an escrow account. When you purchase your replacement (new) property, the QI will deliver the funds to the closing agent and the new property will be deeded over to you.
  • All of the proceeds from the sale of your property must be reinvested into all into the new property. If you do not, you will have to recognize a capital gain based on the amount of money not reinvested.
  • Once you sell your existing property, you have 45 days to identify a replacement property. You may identify more than one replacement property, however  if you identify more than one, you must comply with one of these three rules:
    • 3-Property Rule – You may identify up to three replacement properties without regard to value
    • 200% Rule – You may identify as many properties as you want as long as the total value of all the properties does not exceed twice the value of the property you are selling
    • 95% Rule – You may identify as many properties as you want but the property (or properties) you eventually buy must have a value equal to at least 95% of all of the properties you identified.
  • The replacement property must be of equal or greater value to the property you are relinquishing. You must trade up in value or you will end up recognizing a capital gain for the decrease in value between your old property and new property.

Additional notes:

A couple of additional rules – the debt on the new property must be greater than the debt on the old property. Or, the amount of equity in the new property must be greater than the equity in the old property.

However, trade up in property value and invest all of the proceeds being held by the intermediary into the new property. The debt/equity requirement will take care of itself.

Completing the 1031 Exchange

Once you sell your existing property, you must close on your new property within the earlier of 180 days or the due date of your tax return (including extensions).

The QI will contact the closing agent, complete the necessary exchange paperwork and transfer the funds to escrow for the purchase of your replacement property.

When you file your tax return, you must report the exchange on IRS Form 8824, Like-Kind Exchanges.

There is no penalty if you change your mind about doing a 1031 exchange after engaging a QI. There's also no penalty if you do not meet the 45/180 day requirements.

The QI will return your money to you and you will be taxed on the sale of your property as if you had sold it outright.

Remember, you will still have to pay the QI their fee.

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