If you’re or plan to be a real estate investor, you need to learn about the 1031 stock exchange, which is a strategy that enables you to sell one property for another without incurring taxes in the process.
Does this sound too good to be true? It may be so, but 1031 exchanges are recognized by the IRS and fall within their guidelines. In this article, I will explain how the 1031 exchange works and cover the different types, benefits, and risks.
table of contents
- What is the 1031 exchange?
- Various types of 1031 stock exchanges
- Build-to-fit exchange
- Late exchange
- reverse exchange
- Why exchange 1031?
- deferred income tax liability
- Get rid of the property with a big profit
- Benefit from higher depreciation expenses
- How does the 1031 exchange work?
- The role of a qualified mediator
- Exchange Rules 1031
- Exchange risk 1031
- summary
What is the 1031 exchange?
A 1031 exchange is a transaction in which you “swap” one property for another, allowing you to defer capital gains — and taxes — to a later date.
The strategy is used primarily with real estate investing. And while you can use it once with almost any asset, it’s been restricted almost entirely to real estate since 2018.
Often referred to as “like exchanges,” 1031s are a common strategy used by sophisticated real estate investors to reduce the impact of capital gains taxes on their investing activities.
Various types of 1031 stock exchanges
As with almost any tax-related strategy, there are different types of 1031 exchanges.
Let’s take a closer look at each one.
Build-to-fit exchange
Includes exchange built to suit newly constructed properties but can include properties with major renovations.
Late exchange
Under IRS guidelines, a 1031 exchange must be completed within 180 days. But many exchanges may need this amount of time to complete the process. This is where the late exchanges come in.
Naturally, this adds a layer of complexity to the exchange. If you sell your property before obtaining a replacement, the exchange will be effectively put on hold until the exchange is complete. The proceeds from the sale of your property will be held by a qualified broker and will not be dispersed until the new property is acquired.
reverse exchange
Under a delayed exchange, a new property is acquired after Sell the original. But with the reverse exchange, the new property is obtained before The previous device has been sold.
The financial aspect of a reverse exchange is similar to the financial aspect of a delayed exchange in that the services of a qualified broker will be required.
Why exchange 1031?
Before we get into the nuts and bolts of a 1031 exchange, let’s discuss the benefits and why you might want to do one.
deferred income tax liability
A 1031 exchange allows you to defer tax on capital gains from the sale of your property.
Real estate investments already have a built-in tax advantage with lower long-term capital gain rates. This lower rate applies to properties held for more than one year.
While short-term capital gains — realized in one year or less — are subject to ordinary income tax rates, long-term capital gains tax rates are much lower.
For example, the long-term capital gains tax rate for most taxpayers will be no higher than 15% (compared to a normal tax rate of 22% for short-term gains in the same general tax bracket). Some taxpayers may have a long-term capital gains tax rate of 0%.
By adding a 1031 to the mix, even the long-term capital gains tax is deferred into the future.
This can turn a real estate investment into something like an IRA. And although the gain will be taxable on a future distribution, there are no tax consequences between now and the sale of the final property in the exchange chain.
A 1031 allows real estate investors to use 100% of the gains from real estate sales. This enables the investor to purchase high-priced properties with the possibility of greater profit in the future.
Get rid of the property with a big profit
Let’s say you bought an investment property 15 years ago, which has since doubled in value. If you sell it, you must recognize the gain and pay the applicable long-term capital gains tax on the gain.
But by creating a 1031 stock exchange and purchasing a new property of similar value, the profit on the original property can be deferred for several more years.
Benefit from higher depreciation expenses
One of the advantages of real estate investing is the ability to claim depreciation expense. Investors can write off the cost of purchasing the property over many years. This creates what is known as a “paper expense” – an expense that exists for tax purposes and does not require an out-of-pocket cash outlay.
Paper expenses can be used to protect your rental income earnings from taxes. The more depreciation you can write off, the more rental profit you can protect from taxes.
If you’ve owned the rental property for a long time, your annual depreciation expense will be based on the lower original acquisition cost. But with a 1031 exchange, you can write off the depreciation on the new property based on its (higher) value.
How does the 1031 exchange work?
First and foremost, you must be ready to complete the sale of your existing property and acquire a new property within the 180-day time frame.
Next, the property you plan to acquire must be “of the same type” to the property you’re selling. This does not mean that they need exact copies, but in general they are similar. The properties must have comparable values to avoid receiving cash dividends on the stock exchange, which may be taxable.
The transaction must be set up as an exchange, which means that the “seller” of the property you acquire must also be a willing participant.
Once you have sold your existing property, you will have 45 days to locate a replacement property. All parties to the transaction must be notified of the 1031 exchange. This includes the seller of the replacement property and your chosen qualified broker (see below).
Remember, the closing date for the purchase of the replacement property must occur within 180 days of closing for the original sold property.
The role of a qualified mediator
A qualified broker is necessary for a 1031 exchange. Also known as exchange facilitators, they hold the funds until the transaction is completed. Their role is similar to what a closing attorney or title company would do in a normal real estate transaction.
A qualified broker must have a clear understanding of the 1031 exchange process. They must also provide evidence of compliance, such as completion of the annual SSAE 16 exam. Funds held by the broker must be placed in an account insured by the FDIC and opened for verification by both parties to the exchange at any time.
It is highly recommended that you select your qualified broker prior to beginning the 1031 exchange process. Because of the time constraints these exchanges involve, you will want to be fully aware of both the broker’s competence and qualifications, as well as their operation practices.
Exchange Rules 1031
Because of the tax implications, there are specific rules surrounding 1031 exchanges.
- The real estate to be exchanged must be “of the same kind”. Fortunately, the definition of similar type in real estate is fairly broad. For example, you are likely to have a minor problem exchanging a single-family rental property for four units; However, replacing your primary residence with four single units can be problematic. (For example, you can exchange one rental property for another, but the exchange does not extend to property held for personal use.)
- An exchange can include multiple properties. You can exchange two properties for one or one property for two or more properties.
- Any funds exchanged in the transaction must be kept by a qualified broker. The managers participating in the exchange are not permitted to receive or hold any funds from the exchange.
- Report the transaction to the IRS. Although there is no immediate tax liability from the 1031 exchange, you are still required to report the event on IRS Form 8824, Symmetrical Exchange. The form does not need to be submitted with every 1031 exchange you make, but it must be completed and filed with your individual income tax return in any year the exchange takes place.
Exchange risk 1031
Since a 1031 exchange is more complex than a direct sale, there are risks you should be aware of before proceeding:
- If you make a deferred exchange and fail to obtain a replacement property within 180 days, the capital gain from the original sale will be taxable.
- If the acquisition of the replacement property requires a smaller mortgage than that on the sold property, there may be a tax liability on the difference between the two.
- 1031 exchanges do not eliminate your tax liability; They just postpone it. If you complete a series of exchanges over many years, the end result will be the sale of the finished property at a significant capital gain. That could create a huge tax liability.
- Because the 1031 exchange is complex, it can be more difficult to locate real estate and property sellers willing to participate.
Since the 1031 exchange is, first and foremost, a tax strategy, it is highly recommended that you consult with a tax expert before moving forward.
summary
The 1031 Exchange is a boon to active real estate investors. But before you do one, make sure you know how the process works. Also, consult a tax professional and, if necessary, seek assistance from real estate agents and experienced organizations in the process.