If you’re a real estate investor and not sure what a 1031 Tax Exchange is, this article may very well be worth its weight in gold. A few weeks back, we wrote an article about the conditions of the market, and how we’re seeing unprecedented levels of demand.
This has pushed investors across the country to think about selling their investments, to either liquidate or perhaps use the accrued appreciation to buy more property.
The 1031 tax exchange comes from Section 1031 of the U.S. Internal Revenue Code, which allows businesses to defer federal taxes on some of their real estate investments. Instead of paying capital gains tax when they sell the property, they can purchase another one (following the guidelines of the 1031 exchange) and defer their taxes.
There are some important terms to know when talking about this tax benefit. The property an investor is going to sell, is referred to as the relinquished property. The property that the investor purchases with those funds is known as the replacement property. There is also a qualified intermediary, which is similar to an escrow agent. Their role is to hold the funds from the sale of the relinquished property and ensure that they go to the replacement property.
An important concept to understand, and one of the main incentives for investors to utilize the 1031 tax exchange is depreciation. Tax law allows owners of real estate to take deductions on their taxes for the depreciation of the property. In residential, the depreciation is typically based on a 27.5 life. Each year, as the depreciation increases on the property, the owner has to pay less in taxes.
The tax code is complex and should be handled by professionals. According to the revenue code, the proceeds from the sale of an investment property are still subject to taxation, which is why they’re transferred to a third party, the qualified intermediary.
A question we’re frequently asked about is the limitations to purchases that can be made subsequent to the sale of the property. It’s important to know that it’s required that you use the capital from the sale of the relinquished property, for another piece of real estate. You can exchange residential property for commercial, for example, or vice versa. You would not be able to use the proceeds from the sale to pay off personal debt, or buy a car.
To maximize the utility of this tax law, you should be looking to purchase properties that are either equal, or greater in value than the relinquished property. There are three different conditions as it relates to identifying a replacement property, one of which must be met within 45 days of the sale.
The first option is known as the three-property rule. It states that the buyer must identify three properties within 45 days of the sale of the relinquished property, with the intention of closing on one, two, or all of them. The second option is the 200% rule. It allows the seller to identify an unlimited amount of property so long as the total amount does not exceed 200% of the value of the sold property. The last is the 95% rule. It allows the buyer to identify as many properties as they please, so long as the properties are valued at 95% of their total or more.
As far as the timeline goes, there are a few different methods to be aware of. The first one, and likely the most common, is known as a delayed exchange. The buyer relinquishes his property, the proceeds are transferred to a qualified intermediary, he identifies the replacement, and it’s closed within 180 days.
The second one, is commonly referred to as the build-to-suit exchange. This procedure allows the replacement property to be renovated so long as it falls within the 180-day time limit. Meaning, the buyer can make improvements with the proceeds, so long as they go towards the replacement property and are complete within the standard 180 day period.
The last one that we’ll talk about is a reverse exchange, and it’s exactly what it sounds like. The replacement property is acquired prior to the sale of the relinquished property. Similarly to the delayed method, the replacement property is transferred to a qualified intermediary, and an agreement must be signed. The seller must identify the property they wish to sell within 45 days, and close on it within 180 days, so that title of replacement property can be transferred.
Tax laws can be convoluted and often confusing. Taking the time to understand how to maximize tax benefits is going to be a major component of any real estate investors career. If you’re looking to learn about real estate investing, fill out the form below!