The 1031 exchange refers to the use of section 1031 of the United States Internal Revenue Code (26 U.S.C § 1031), and it allows real estate investors to make the most out of their investments by exchanging one investment property for another similar property.
While this might seem straightforward, this assumption might be misleading as there is much more to the 1031 exchange rule, and real estate investors who intend to use 1031 exchange for their own advantage must be well aware of the more in depth details and specifics of its law before they start taking advantage of it.
This article aims to explore the most important aspects related to the 1031 exchange rule and break them down into more detail in order to help real estate investors use this section of the US Internal Revenue Code to achieve a more effective and more profitable real estate investment career.
So, how is the 1031 exchange rule used in real estate investing? And what are the most important aspects related to it that every real estate investor should learn about? Let’s find out.
Note: The following information about the 1031 exchange was a contribution from Michael Lantrip, author of How to Do a Section 1031 Like-Kind Exchange and owner of the website S1031Exchange.com. As an expert on the matter, Michael was kind enough to provide us with the information needed to write this article.
The 1031 Exchange in Real Estate Investing
In real estate investing, the 1031 exchange has a very straightforward implementation when it comes to increasing your revenue and profits whilst avoiding the drastic taxes that may apply to your investment and cut your profits short.
How to use the 1031 exchange in real estate investing?
It’s simple.
The 1031 exchange is a tax-deferred exchange that allows an investor to dispose of his/her asset and acquire a new similar asset without generating a tax liability from selling the first asset. This can apply to real estate investing to include the selling of a real estate property and the purchase of another similar real estate property without having to pay taxes on the profits made from selling the first property.
Basically, what a real estate investor can do using the 1031 exchange (also called the like-kind exchange) is to purchase a starter investment property, and after a few years, once the property has generated a profit and/or appreciated in price, the real estate investor can then sell the property and use the cash earned from the sale to purchase another investment property that is bigger and/or better without having to pay any taxes on the cash earned from the sale as long as the new property is similar to the one sold.
Related: Everything Real Estate Investors Should Know About Tax Season
Successful and savvy real estate investors typically use this technique to snowball their investments and keep growing their business overtime while avoiding paying taxes on the sale of each property they own. They keep selling properties and purchasing new better ones, effectively growing their investment business and enlarging it over the years.
The Rules of the 1031 Exchange
But the “rules” for the like-kind 1031 exchange are not something that you can simply look up and understand.
They have rather evolved over the years from the statute, the URS Revenue Rulings, and, to a lesser extent, from Private Letter Rulings.
Additionally, as the various positions of the IRS were tested in the US Tax Court and Federal District Court by taxpayers, a generally accepted body of rules has come into existence.
So, before we delve deeper into the rules, let’s first take a look at the statute:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
Michael Lantrip has divided the body of the rules into nine basic rules and seven additional rules. And so, this article will cover the nine basic rules, while the other seven rules will be covered in another article.
Related: What You Need to Know About Real Estate Taxes as an Investor
Without further ado, here are the nine basic rules of the 1031 exchange according to Michael Lantrip:
Like-Kind Property
This rule of the 1031 exchange states that in order for the exchange to take effect, the properties must be like-kind (hence the name – like-kind exchange).
According to this rule, the property that you sell, which is called your Relinquished Property, will either be a real property or a personal property, or both, while the property that you buy, which is called the Replacement Property, will either be a real property or a personal property, or both.
The rule states that you cannot exchange a real property for a personal property or vice versa.
In order for the exchange to apply, the real properties must be like-kind, and the personal properties must be like-kind to each other.
So, what does like-kind mean in this context?
Like-kind does not refer to the appearance of the properties, but rather to the properties being like-kind in character and their use.
This means that if your Relinquished Property is a property that you are holding for a productive use, whether that use is in a trade, a business, or for investment, then your Replacement Property must also be a property that you intend to use in a trade, a business, or for investment.
For example, you can exchange a single-family rental property for an apartment building, for a tract of vacant land, or for any other combination, as long as both properties are like-kind in character.
And while the rule is very different for personal properties, as they have to be almost identical in order to qualify for the section 1031 treatment, this article is aimed towards the implications of the 1031 exchange in real estate investing. If you’d like to learn more about the rules of section 1031 with regards to personal properties, you can learn more about them in Michael’s book How to Do a Section 1031 Like-Kind Exchange.
Business or Investment Property
While this rule might be similar to the first rule, with more elaboration specific to real estate investing, Michael has decided to give this rule its own section due to its importance for real estate investors in particular.
This rule states that both properties must be business or investment properties.
This means that your Relinquished Property must meet the definition of “property that is held for productive use in a trade or business or for investment.”
Therefore, the property must have been used as an income property or an investment property for at least the past year.
Michael goes on to say that “in a sense, the property itself qualifies you to use Section 1031 Exchange”.
For a more in-depth explanation of what this means exactly, you can visit Michael’s website and read his article on this specific topic.
When it comes to the Replacement Property, however, the criteria are a bit different.
Since a real estate investor does not own the Replacement Property yet, the property cannot meet the qualification of Section 1031 except by being the correct type of property.
The Replacement Property, therefore, has to meet the definition of a property “which is to be held either for productive use in a trade or business or for investment.”
Related: Your Guide to Short-Term Rental Property Tax Deductions
So, you as a real estate investor will personally meet the qualifications by your intention to hold the property as an income property or as an investment property. But you still have to actually hold the property for the intended purpose.
Michael explains this aspect in more depth in his article here.
Note: Looking to find investment properties in your area with readily calculated taxes? Click here and start searching!
Replacement Property Price
When it comes to the price of the Replacement Property, this rule states that the price you pay for the Replacement Property must be equal to, or greater than, the sales price of the Relinquished Property.
This includes the price of the Replacement Property and all costs of its acquisition, while the sales price of the Relinquished Property will be calculated after the deduction of sales expenses.
Net Sales Proceeds
According to this rule, all of your Net Sales Proceeds from the sale of your Relinquished Property must be used in the purchase of your Replacement Property.
So, what are the Net Sales Proceeds?
The Net Sales Proceeds are not the Net Sales Price of your Relinquished Property, nor are they your Capital Gains. It is the amount of money that you are entitled to receive at the closing of the sale of your Relinquished Property, or the check that will be given to your Qualified Intermediary by the Closer.
If you choose to take a portion of the Net Sales Proceeds, the amount you take will be taxable.
Same Taxpayer
This rule is straightforward and self-explanatory. The rule states that the name that goes on the deed when you receive title to the Replacement Property must be the same name that was on the deed that transferred the title of the Relinquished Property.
In this case, the taxpayer can be the real estate investor as an individual, as an LLC, as a C Corporation, or as a Partnership.
In the case of a C Corporation or an LLC, it has to be categorized under Subchapter S status.
Additionally, as a sort of exception to this case, if you sell a Relinquished Property as an individual, and you purchase a Replacement Property as an LLC which you are the sole member of, and for which you have chosen to be treated by the IRS as a Disregarded Entity for tax purposes, then the seller and the buyer will be considered to be the same for the purpose of the 1031 Exchange.
45-Day Period
This is one of the important and less known rules related to the 1031 Exchange. The 45-Day Period rule states that after you sell your Relinquished Property, on your Exchange Date, you have 45 days in which to identify in writing to your Qualified Intermediary a list of the possible properties that you will purchase as Replacement Property.
There are three different ways that you can choose from in order to qualify for this rule:
- First, you can choose up to three properties, disregarding the value of each, or the total value of all three of them.
- Second, you can choose as many properties as you please as long as the total value of all properties you choose is not higher than 200% of the value of your Relinquished Property.
- Third, you can choose as many properties as you want, disregarding the 200% limit on value, as long as you end up closing on enough properties to amount to 95% of the total value of all of the properties that you choose.
In order to qualify for the 1031 Exchange, you must actually purchase one or more of the properties which you have chosen.
Related: The Best States With No Property Tax for Real Estate Investing
180-Day Rule
This rule is very straightforward, and it states that you must close on the purchase of your Replacement Property within 180 days after the Exchange Date.
If you fail to do so, the following consequences will take place:
- Your Net Sales Proceeds will be distributed to you by the entity holding those funds.
- You will lose permission to use the 1031 Exchange.
- You will be obliged to pay the Capital Gains Tax and the Depreciation Recapture Tax on the sale.
On the bright side, the IRS will not impose penalties and interest.
Related Party
According to this rule, you cannot sell your Relinquished Property to, or buy your Replacement Property from, or swap properties with, a person related to you, a “related party,” without having certain conditions imposed.
In this case, the “related party” is defined as your spouse, sibling, child, grandchild, parent, or grandparent. It can also include a corporation, partnership, LLC, or any similar business in which you own more than 50% of the interest, in which case the interest could also include your spouse’s ownership of the said business.
Related parties are allowed to swap properties directly as long as each party holds the acquired property for a period of more than two years after the date of the last transfer.
In the case of a swap, each related party must continue to file Form 8824 for two years after the year of the Exchange.
Note: Looking to find investment properties in your area with readily calculated taxes? Click here and start searching!
Also, you can sell your Relinquished Property to a related party as long as he/she holds the property for the two-year period described above.
In the case that a related party fails to hold the property for two years, then the Section 1031 Exchange will become invalid, in which case the taxes, penalties, and interest will be imposed on both the buyer and the seller parties.
Additionally, you will be held to the same two-year filing requirement for Form 8824, except in this case it could turn into three years for you. This is because the period will start to run for you when you acquire your Replacement Property, which could be 180 days after the first closing, and it could cover three tax-filing periods instead of two.
As for purchasing a Replacement Property from a related party, you will also not be prohibited from doing so, but you will have the same two-year reporting requirement for Form 8824.
Finally, it is most likely that the IRS will audit the transaction in these cases, as this is where they typically find the most abuse of the Section 1031 Exchange program where family members try to manipulate the system for their own gains.
Qualified Intermediary
This rule states that you cannot have actual receipt of, constructive receipt of, or control over, the Net Sales Proceeds from the sale of the Relinquished Property.
In order to abide by this rule, you can do an Assignment of Benefits of your sales contract on your Relinquished Property to an independent third party who will hold the funds for you.
The third party, in this case, is usually a “Qualified Intermediary”, which is the term used in the Internal Revenue Code.
The word “qualified” here, however, doesn’t mean that the individual or entity is qualified in any way to do anything. Instead, by definition, a Qualified Intermediary is an entity that is not disqualified from providing the service by reason of having had a family or business relationship with you during the past two years.
A Qualified Intermediary, then, refers to a party that is not disqualified by the definition, and it does not refer to his/her ability or inability to do the work.
Additionally, the activities of the Qualified Intermediary are completely unregulated.
In their Tax Gap Series fact sheet, the IRS warns about Qualified Intermediaries (despite the IRS being the one who requires you to use them) by saying:
“Be careful in your selection of a qualified intermediary as there have been some recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligation to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.”
Basically, what this means, and what the IRS is trying to warn you about, is the following:
If you sell your Relinquished Property for $400,000, and you give the money to a Qualified Intermediary to hold it until you’re ready to purchase your Replacement Property, and that money goes missing for any number of reasons, not only will you lose out on the purchase of the Replacement Property, but you will also have lost the money you made from selling the Relinquished Property, in addition to you now having to pay the IRS $80,000 in Capital Gains Tax.
For this reason, it is extremely important to be extra careful when choosing the Qualified Intermediary.
For more elaboration on any of these rules, and to see how they are applied in real-life situations and using real numbers, you can find five examples here.
Also, if you’d like to learn more about the 1031 Exchange, you can read all about it in Michael Lantrip’s book – How to Do a Section 1031 Like-Kind Exchange.
Closing Thoughts
Whether you’re using the 1031 Exchange in your real estate investments or not, there are always opportunities to make massive amounts of money investing in real estate in the US housing market.
Note: Looking to find investment properties in your area with readily calculated taxes? Click here and start searching!
If you’re looking to find the best investment properties and turn them into pure profits, or if you’re looking for Replacement Properties for your 1031 Exchange, you can always head over to Mashvisor and start searching there.
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