Roth&Co’s latest video series: Real Estate Right Now.
Presented by Alan Botwinick and Ben Spielman, co-chairs of the Roth&Co Real Estate Department, this series covers the latest real estate trends and opportunities and how you can make the most of them. This episode discusses how the tax-deferred benefits resulting from a 1031 exchange can help investors build a more valuable real estate investment portfolio.
Watch our short video:
What is a 1031 exchange?
In 1921, Section 1031 was entered in the US Internal Revenue Code and the ‘1031 exchange’ was born. Under specific criteria, a 1031 exchange allows an investor to sell his property, reinvest in a similar property of equal or greater value, and defer payment of capital gains taxes until that second property is ultimately sold.
Eligibility for a 1031 exchange is reserved for real property that is “held for productive use in a trade or business or for investment”. This kind of property could include an apartment building, a vacant lot, a commercial building, or even a single-family residence. Properties held primarily for personal use do not qualify for tax-deferral under Section 1031. There are specific types of property that don’t qualify for a 1031 exchange, including business inventory, stocks and bonds, securities and partnership interests.
Your reinvested property must be “like kind,” or of the same nature, as the property being replaced. The definition of “like kind” is fairly loose, and IRS considers real estate property to be like-kind regardless of if or how that property has been improved.
Benefits
The obvious benefit of a 1031 exchange is that you get to hold onto your money for longer and have more funds available to take advantage of other investment opportunities. A 1031 exchange could also yield tax-shielding benefits, such as depreciation and expense deductions and capital returns at a refinance. A 1031 exchange is also useful for estate tax planning. Tax liabilities end with death, so if you die without selling a property that was invested through a 1031 exchange, your capital gains tax debt disappears. Not only that, but your heirs will inherit the property at a stepped-up market-rate value.
Details and Dangers
A 1031 Exchange has a very strict timeline. The replacement property, which must be of equal or greater value, and must be identified within 45 days. The replacement property must be purchased within 180 days. One potential pitfall investors face when deciding to implement a 1031 Exchange is that, because of the time pressure, they may rush to commit to an investment choice that is less than worthwhile. For that reason, potential investors are advised to plan ahead when considering a 1031 exchange. In order to get the best deal on a replacement property, don’t wait until the original property has been sold before starting to research replacement options.
45-Day Rule
When an investor sells his property and chooses to do a 1031 Exchange, the proceeds of the sale go directly to a qualified intermediary (QI). The QI holds the funds from the sold property and uses them to purchase the replacement property. As per IRS 1031 rules, the property holder never actually handles the funds. Also within the “45 day rule”, the property holder must designate the replacement property in writing to the intermediary. The IRS allows the designation of three potential properties, as long as one of them is eventually purchased.
180-Day Rule
The second timing rule in a 1031 is that the seller must close on the new property within 180 days of the sale of the original property. The two time periods run concurrently, so for example, if you designate a replacement property exactly 45 days after your sale, you’ll have only 135 days left to close on it. To determine the 180-day time frame, the IRS counts each individual day, including weekends and holidays.
1031 Exchange Tax Implications
What happens when the purchase price of your replacement property is less than the proceeds of the sale of your original property? That cash – known as the “cash boot” – will be returned to you after the closing on the replacement property, but it will be considered as sales proceeds and taxed as a capital gain.
Another important factor to remember is that if you have a mortgage, loan or other debt associated with the exchange, and your liability goes down, that sum will also be treated as income. For example, if you had a mortgage of $1 million on your original property, but your mortgage on the replacement property is only $900,000, you will enjoy a $100,000 gain. That $100,000 is the “mortgage boot”, and it will be taxed.
The 1031 Exchange is a tax-deferred strategy that any United States taxpayer can use. It allows equity from one real estate investment to roll into another and defers capital gains taxes. It’s like having an interest free loan, compliments of the IRS. Savvy investors can put that extra capital to work and acquire a more valuable investment property, painlessly building wealth over time. Over the long term, consistent and proper use of a 1031 Exchange strategy can provide substantial advantages for both small and large investors.
This material has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
