BASICS OF 1031 PROPERTY EXCHANGE
Owners of commercial and residential investment property gain tremendous advantages by working with a Smith Boone advisor to understand the set of IRS rules for 1031 exchanges. Investors are commonly subject to significant capital gains tax when you make more off selling an investment property for profit, so it’s important to work closely with your Smith Boone commercial broker to understand 1031 exchange rules and make the best decisions for your investment property. The IRS 1031 exchange approach is a great tax advantage for real estate investors and will allow you to defer paying taxes on your investment property sales proceeds long into the future.
How Does a 1031 Exchange Work?
In a 1031 exchange, the IRS defines several rules to follow. After you sell your property in a 1031 exchange, the money will be held in escrow by a qualified intermediary. The qualified intermediary is an independent service firm that monitors and manages your 1031 as a independent third-party. To successfully perform a 1031 exchange, you will not be able to access your money from the sale of your property. You will identify and contract to close on replacement property, and your qualified intermediary will assist you with using the funds to purchase the property on your behalf.
The amount you want to shelter from taxes in your 1031 exchange must be used only for purchasing a new property. Any amount of money that you choose not to roll into another investment will incur capital gains taxes on the sale. To get the tax benefits you will need to exchange one investment for another without receiving cashing out at closing. If your situation requires that you receive some cash at closing, you can simply pay taxes on the amount you receive and reinvest the balance to avoid taxes on the reinvested amount.
1031 Exchange Like Kind Property
1031 exchanges must be completed with like-kind properties. This rule is true and applicable; however, it is commonly misinterpreted. The definition of like-kind property is not as restrictive as most investors initially think. Like-Kind might be best interpreted as investment property for investment property. But many investors think they must exchange a house for a house or apartment building for apartment building—which is not the case. The properties do not need to be the same type or asset class. For example, if you sell an industrial building, you can use the proceeds to purchase an apartment building or you might sell investment land and purchase an self-storage complex. While international properties are not considered eligible for like-kind 1031 exchange, you can conduct a 1031 exchange with almost any property in the United States.
Three Options to Structure Your Exchange
Three Property Option
In one approach to 1031 exchange, you identify as many as three possible properties to purchase, as long as you buy at least one of these properties. The IRS sets this limit of three properties. Many real estate investors limit their options to three properties to minimize paperwork and to simplify their exchange.
200% of Value Option
Under the 200% rule, you can identify however many replacement properties you wish to purchase, so long as the combined fair market value of all of the properties together do not equal more than 200% of the property you relinquished at sale. As an example, if you sell a property for $1,000,000, then the combined fair market value of all replacement properties should not exceed $2,000.000, because it is double or 200% of your original sale amount.
95% of Value Option
Under the 95% rule, you ignore the 200% rule and find whatever number of possible replacement properties you desire, for any amount—so as long as you purchase 95% of these properties’ total combined value. For example, if you sell a property for $2,500,000, you can identify five properties with a total worth of $2,900,000. However, you would need to purchase at least 95% of the total combined properties’ value or $2,750,500.
Investment Properties Only!
Your primary residence cannot be traded in a 1031 exchange. This means you cannot sell your personal home or any home that you own and regularly visit in a 1031 Exchange. If you have lived in the home in the past few years, you likely will not be able to exchange it. Vacation and second homes that you use or have used on a regular, personal basis may not be eligible for tax benefits of 1031. Be sure to contact your Smith Boone commercial real estate advisor to discuss your situation before you sell or buy.
For investors involved in residential rehabs, commonly a fix-and-flip residential home does not count as a 1031 exchange property either—typically these homes as held short-term as a dealer instead of for long term investment. Properties in a 1031 exchange need to have been used in a business or a trade -or- held specifically as an investment.
45-Day & 180-Day Exchange Rules Explained
The most common approach to a 1031 exchange is known as a delayed 1031 exchange. In a delayed exchange you need to observe the 45-day and 180-day rules. When you sell your property, the qualified intermediary you designated will receive the money. Within 45 days of property sale, you will designate your replacement property or properties to your QI intermediary in writing and state the property you would like to acquire as replacement. When you make these elections, you will to follow the Three Property rule, the 200% rule or the 95% rule to define your approach and properties.
Then in a delayed 1031 exchange, you should arrange to close on your new property within 180 days after the sales date of your old property. Or the replacement property should be received by the tax return’s due date including extensions. So if the 180-day rule is earlier than the due date of your tax return, then you will need to close on your new property inside that 180-day period.
Contact Us to Discuss and Plan your 1031 Exchange
At Smith Boone, we specialize in in assisting clients in planning and executing their 1031 exchanges. Be sure to contact your Smith Boone commercial real estate broker to discuss your property portfolio and consider the benefits of using 1031 Exchange to maximize results.
Let Smith Boone show you how to defer taxes and reinvest your full proceeds from an investment real estate sale.