The 1031 Exchange: The Basics
A 1031 Exchange allows real estate investors to defer capital gains taxes on the sale of a commercial property. This is possible provided they quickly buy another qualifying commercial property as per IRS 1031 Exchange rules, the IRS rules in Internal Revenue Code Section 1031, to be precise.
In other words, if you sell a commercial property, you need not pay tax on the money gained by the sale, at least not at that point in time. Assuming you use a 1031 Exchange, you can invest every bit of the proceeds in the new commercial property and have capital gains tax deferred.
Because it confers this benefit, a 1031 Exchange is also commonly called a Tax Deferred 1031 Exchange, a Tax Free Exchange, a Like Kind Exchange, a Real Estate Exchange, a Property Exchange, or an IRS Exchange. Whichever of these terms you happen to hear, the speaker is talking about the same thing.
It’s important to understand that tax deferral doesn’t mean you need neverpay the tax, only that you needn’t pay it for the time being.
How Does a 1031 Exchange Work?
In a 1031 Exchange, one commercial property is sold and a similar one bought soon thereafter. Specifically, as per IRS 1031 Exchange rules, you have 45 days after you sell the first property to identify potential replacement properties, You make the identification in writing, sign it, and present it to someone involved in the exchange, like the current owner of the new property of a qualified intermediary, You have to give the street address of the potential replacement property and/or a valid legal description. Then you must buy the replacement property and complete the transaction within 180 days of the sale of the first property.
The property you sold and the one you buy don’t have to be extremely similar. As a hypothetical example, if you sell one restaurant, you don’t have to purchase a different restaurant. The new tax plan that went into effect after December 2017, didn’t impose any new restrictions on 1031 Exchange real estate transactions even though other asset classes were adversely affected from the perspective of investors.
It also helps investors who aspire to leave a substantial estate that the tax exemption at the time of death doubled to $22.4 million for couples. As a result, investors can keep trading up while taking advantage of the 1031 Exchange option including 1031 Exchange Financing and not pay tax at the time of death on profits up to $22.4 million.
More Information About 1031 Exchanges
Any real estate property bought for a business or investment purpose qualifies to be sold or purchased in a Like Kind exchange. That can include a single-family house but not items like stocks, bonds, notes, shares in a purchase, a personal residence, property in another country, or “stock in trade.” Houses built by a developer and then offered for sale and houses purchased, improved, and then “flipped” are examples of stock in trade.
The best way to get started on a 1031 Exchange is to contact an Exchange Facilitator. The more information about the properties to be sold and acquired that you can provide the facilitator during your first conversation, the more productive that conversation is likely to be.
You can find information about facilitation companies on the Internet. It’s important to understand that your exchange facilitator should not be acting as an “agent” as well. This means that attorneys, escrow agents, and real estate agencies are inappropriate choices. The facilitator’s services typically cost between $400 and $700.
Ultimately, to set up a Like Kind exchange, you’ll need to supply the Exchanger’s name, address, and phone number, and the escrow officer’s name, address, phone number, and escrow number, It will help your exchange facilitator considerably to also know what property you’re selling, when you acquired it, what it cost, how it was vested, what you used it for, whether there’s a sale pending and if so, the closing date, who’s doing the closing, and the value, equity, and mortgage of the property. Similarly, the Exchange Facilitator will want to know what property you hope to purchase, what would the purchase price, equity, and mortgage be, if purchase is pending, who’s taking care of the escrow, and how will the property be vested.
When identifying potential replacement properties, you have three options. You can identify three of any value while intending to buy at least one, you can identify any number of properties with a combined value of no more than 300% of the property you’re selling, or you can identify any number of properties with a combined value over 200% of the value of the property you’re selling with the understanding that 95% of the market value of the properties you’ve identified must be acquired.
Closing costs can be paid with exchange funds provided the costs fall into the category of Normal Transactional Costs, also known as Exchange Expenses. Legal fees, finders fees, escrow fees, inspection testing fees, title insurance fees, recording fees, document fees, messenger fees, exchange fees, statement fees, notary fees, processing fees, property taxes, transfer taxes, tax service and sales commissions are Exchange Expenses. Replacement property loan acquisition fees, security deposits, points, utilities, rent proration, mortgage insurance, property liability insurance, lender’s title insurance, application fees, assumption fees, homeowner dues, repairs, and termite work are not. Inspection testing fees and appraisal fees may or may qualify as Normal Transactional Costs depending on the specifics of the particular transaction.
The 1031 Exchange need not be “all or nothing.” A Like Kind exchange can go forward even if you take money out, but you’ll have to pay capital gains tax on that portion of the money.
Vacation homes can qualify for a 1031 Exchange provided certain conditions are met. The vacation property must have been held for at least 24 months prior to the exchange, for each of the 12-month periods that make up those 24 months, the home must have been rented out to another person at a fair rental fee for at least 14 days, and the homeowner must have limited his personal use of the house to not more than 14 days or 10% of the number of days during the 12-montn period when it was rented out at a fair rental price.
If you make a Like Kind exchange and purchase a rental home, it is possible to move into it yourself, but the IRS will look at this and evaluate whether the property then qualifies as one acquired for investment purposes. Some experts recommend using the rental home strictly as an investment for at least one year before you consider taking up residence there.
In a 1031 Exchange, the property being sold and the one being acquired need not be in the same state. In fact, it’s common for a Like Kind exchange to extend across state lines although, to avoid unpleasant surprises, it’s important to understand the applicable tax laws in each state.
The 1031 Exchange Loan
As mentioned above, investors who seek to take advantage of a 1031 exchange often want to trade up. Because of this, the proceeds of the sale of the original property won’t be enough to cover the cost of the replacement property. A 1031 Exchange Loan is a commercial mortgage loan that covers the difference and allows the investor to make the purchase.