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If you have experienced large appreciation in your real estate investment and you are planning on selling it, you need to become familiar with a “1031 Exchange”.
Normally when you sell real estate, the IRS will tax your gain on the sale. The federal capital gains rate is currently 15%. Section 1031 of the Internal Revenue Code (IRC) provides an exception to that general rule. It allows the deferment of your capital gains tax liability, provided that certain rules are met and that you follow a certain process for exchanging. It is referred to as a “1031 Tax-Deferred Exchange”.
1031 Exchange Rules – The Delayed Exchange
You need to have at least two properties in your exchange: one (or more) that you are selling, and one (or more) that you are replacing it with.
Not all properties qualify for an exchange: they must be held for productive use in a trade or business or for investment (e.g. raw land, rental apartments, office buildings, warehouses, industrial, retail). Importantly, properties held for personal use, such as one’s personal residence, do not qualify.
The properties that you are exchanging do not have to be identical in nature. They just need to qualify as real property. You can exchange a piece of raw land for a rental condo in Port Charlotte, for instance, or sell a 2 bedroom rental condo and replace it with a 3 bedroom rental house or sell an apartment building and replace it with a warehouse, etc.
To defer all of your capital gains tax, (1) the value of the replacement property must be equal to or greater than the sales property, and (2) all of the sales equity (cash remaining) must be reinvested. If you are unable to reinvest all of your sales proceeds, you still may do a 1031 exchange. But just remember that any funds that are not reinvested are liable for tax.
The most important requirement for a successful exchange is that you cannot touch the money. An independent middleman – called a Qualified Intermediary (QI) – must be used. If you sell a property and touch the sales proceeds, the IRS will tax you. In a 1031 exchange, however, rather than you receiving the sales proceeds, the qualified intermediary receives it. The intermediary holds that money on your behalf until that time when you direct it to be sent towards payment of your replacement property.
Working with the assistance of a realtor trained in 1031 tax exchanges, you identify what to sell and buy. But, the intermediary is the legal vehicle through which the properties are transferred.
Please remember these three critical timing rules.
The delayed exchange just outlined covers the most basic idea of 1031 tax exchanges . More elaborate exchanges are possible however. Keep in mind that the following exchanges are much more involved, and also considerably more costly.
1031 Exchange Rules – The Reverse Exchange
A reverse exchange is the purchase of the replacement property prior to closing on the relinquished property. An investor may need to consider a reverse exchange in a seller's market, where properties are selling quickly and inventory is scarce. The most common variation (often called "parking the replacement property") involves the qualified intermediary first purchasing the replacement property. When the relinquished property is sold at a later date, the qualified intermediary completes the exchange by deeding the replacement property back to the exchanger. It is especially crucial that the qualified intermediary has in-depth knowledge of the steps and precautions necessary in these complex transactions. This type of exchange can be very costly, usually starting around 8,000 dollars just for the qualified intermediary fees.
1031 Exchange Rules – The Improvement Exchange
Improvement (build-to-suit or construction) exchanges allow an investor to use exchange proceeds to either (1) make improvements to an existing property or (2) build a new replacement property. This variation is extremely popular because it provides the opportunity to purchase properties needing renovation or to acquire bare land and build to an investor's exact specifications. The qualified intermediary makes improvements to the replacement property during the exchange period and transfers the improved property back to the Exchanger by the 180th day. Advance planning is essential; normal construction delays, inclement weather and obtaining government permits can make it a challenge to complete the needed improvements within the 180-day exchange period.
Jason and Amanda Painter specialize in helping clients with all types of 1031 exchanges. Just fill out the form below to get more information, or just call us at 941-740-8000. If you would like 1031 info mailed to you, please include your mailing address.