Do you own an investment property? Planning on selling it and buying another one? Check out this blog first, and learn everything you need to know about the 1031 exchange rules.
What Is the 1031 Exchange?
If you haven’t heard of it before, it’s definitely something you should consider if you’re planning on selling an investment property and buying a new, similar one. A 1031 exchange gets its name from Section 1031 from the U.S. Internal Revenue Code. Also called a Starker or Like-Kind exchange, the 1031 exchange is a powerful tax-deferment strategy that many investors use.
Just to give a brief description of what a 1031 exchange is, this strategy allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property. This is why it is sometimes referred to as the “Like-Kind exchange.” Most property swaps are taxable as sales, but if yours meets the 1031 exchange rules and requirements, there won’t be any tax at the time of the exchange.
Many successful real estate investors follow the 1031 exchange rules because this exchange has more benefits than just avoiding taxes. There’s no limit on how many times you can use this strategy, but there are a couple of details to know before taking it on. Check out these 1031 exchange rules for a clearer picture of how it actually works in the real estate business.
Related: 1031 Exchange – The 9 Basic Rules That You Need to Know
1031 Exchange Rules for an Investment Property
#1. A 1031 Exchange Isn’t for Personal Use
This is something anyone considering to do a 1031 exchange needs to know. The 1031 exchange rules are only applied for the purchase and sale of investment property. This means you cannot swap out your primary residence for another home. Personal property no longer qualifies for a 1031 exchange after the tax reform 2018. Before, some exchanges of personal property like franchise licenses, aircraft, and equipment qualified. However, now only real estate qualifies so if you’re selling your property, you need to be buying an investment property with those proceeds to qualify for a 1031 exchange.
#2. Definition of a Like-Kind Property
“Like-kind” is actually a very broad term. It means that both the original and the replacement property must be of the same nature or character, even if they differ in grade or quality. So for example, you can exchange a rental property for a commercial building, or another type of income property (such as an apartment building) for vacant land. As long as they are similar in nature, the swap is following the 1031 exchange rules and is permissible. It’s important to note that both properties in the exchange must be within the U.S. to qualify.
#3. Replacement Property Should Be of Greater or Equal Value
This is a very important factor to pay attention to when searching for a replacement property for the swap. The IRS requires the net market value and equity of the property purchased to be the same as, or greater than the property sold. This is to avoid paying any taxes on the sale of your investment property. Otherwise, you’d end up paying some percentage of the tax.
Related: 9 Factors to Find the House Market Value of Your Property
#4. You Can Do a Delayed Exchange
There are four main types of swaps allowed under the 1031 exchange rules:
- Construction/improvement exchange
The delayed exchange is the most common type of exchange chosen by investors today. This is the case when the original property (relinquished property) is sold before the replacement property is found. This is usually the case for many investors since it’s not always easy to find someone who has the exact property you want and wants the exact property you’re offering.
To solve this issue, a middleman comes into the picture. This middleman, known as the “Qualified Intermediary”, holds the cash after you “sell” your property and uses it to “buy” the replacement property for you. This three-step process is still considered a swap under the 1031 exchange rules.
Note: Under this strategy, the 1031 exchange rules require an investor to find a replacement property in a maximum of 45 days and to conclude the exchange within 180 days.
#5. You Can Not Receive any “Boot”
This is a follow-up for the third rule which talked about acquiring an “equal or greater value” replacement property. If you receive any cash, it’s taxed. But how can it be taxed under section 1031? Well, let’s take an example to better understand this partial 1031 exchange. Let’s say you sold your original property for $500,000, but the replacement property is only worth $450,000. Following the 1031 exchange rules, that remaining $50,000 would be considered “boot” and is taxed as a capital gain.
Why You Should Do a 1031 Exchange
When and why you want to do a 1031 exchange can differ based on each investor, but the main benefit remains the same for all: the tax deferral. Selling an investment property leaves you on the hook for the capital gains tax. Here, a 1031 exchange is much more than simply selling an investment property and purchasing another one. So when is a 1031 exchange the right strategy for you? See for yourself- do any of the following reasons apply to your current situation?
Related: The Tax Benefits of Real Estate Investments
When to do a 1031 Exchange:
- One of the benefits of investing in real estate is depreciation. It’s also an essential concept to understand the full benefits of the 1031 exchange. If a property sells for more than its depreciated value, you may have to recapture the depreciation. Depreciation is included in your taxable income. Since recaptured depreciation increases with time, you might want to engage in a 1031 exchange to avoid the result of increased taxable income.
- You might want to replace your low-income/high-maintenance property for a high-income/low-maintenance property without paying a significant amount in taxes.
- Swap out a property you’re managing yourself for one that is already managed.
- Diversifying your assets. Remember, the 1031 exchange rules basically allow any exchange in real estate property as long as it isn’t a primary residence.
There are a number of reasons behind using the 1031 exchange in real estate investing. Although it sounds like a great strategy, it can be quite complex at times so it’s recommended that 1031 exchange transactions are handled by professionals.
Related: How a 1031 Exchange Can Help You Buy More Rental Properties
If you need help with the next purchase of an investment property, use an investment property calculator for a full analysis. You can find this tool along with many other real estate investment tools at Mashvisor. To start your 14-day free trial with Mashvisor and subscribe to our services with a 20% discount after, click here.