1031 Exchange

Introduction to 1031 Exchange

The 1031 exchange is one of the most beneficial advantages to a real estate investor in terms of tax benefits. And it allows the investor to keep their capital invested throughout the lifetime of their investment career without having to take portions of it and pay capital gains taxes with it.

How 1031 Exchange Works

This is the taxpayer who is taking advantage of the 1031 exchange. In a typical buy sell transaction, the investor would receive cash from the buyer in exchange for the deed At that point, a portion of that money would need to go to the IRS in the form of capital gains taxes, assuming that the seller or the investor made a profit and had some appreciation in the transaction. 

If you had say a $1 million gain and we're paying a 35%. Tax rate then the taxpayer would be liable for approximately $350,000 to the IRS. 

The 1031 exchange came about because an investor named Starker wanted to trade lands for other real estate, and he felt like because there wasn't a capital gain that was realized he shouldn't be liable for the taxes. so a one-for-one deed swap between two real estate owners qualifies and does not trigger any sort of capital gains liability. 

Normally what happens these days is what's called a delayed exchange. The delayed exchange gives the investor the opportunity to sell one property, and then within a certain timeframe, find another property from a different and invest in that without having to pay capital gains taxes. 

So the investor wants to sell to Buyer and buy from Mr. Seller. in order to qualify for 1031 exchange, there can be no money that goes from the buyer to the investor. 

Role of Qualified Intermediary in 1031 Exchange

So what the IRS allows is what's called a qualified intermediary, and that needs to be somebody who is arms length from the transaction, typically a 1031 exchange company or other professionals that can act as a neutral third party. 

And what happens is, when the investor wants to sell, they give the deed to the qualified intermediary. The qualified intermediary then gives that deed to the buyer and the buyer gives the cash to them. 

Now, at this point, the qualified intermediary is holding onto the cash The investor is out looking for a new replacement property. If they find one, they instruct the intermediary to give the cash to the seller in exchange for the deed, and then the intermediary gives the deed back to the investor. This gives the investor the same effect on the exchange of the property as if they had just swapped deeds, because the investor never takes possession of the cash. 

In the 1031 exchange process, taking cash is called boot. As long as the investor does not receive any boot cash or debt relief, then they can avoid the capital gains taxes.

Key Components of 1031 Exchange

There are certain components to this that you need to know, and let's go through them one by one. 

First, is that a 1031 is a tax deferral strategy, not a tax deduction. It simply allows the investor to defer realizing capital gains until a later date by rolling them into the next investment. 

If the investor doesn't have a significant capital gains liability, it may not make sense for them. There are strict requirements, costs, and deadlines that must be managed in a 1031. So it's important to talk to an attorney or an accountant before beginning the 1031 exchange process. 

Understanding 'Like-Kind' Property

Next, is the 1031 exchange may only be used when buying and selling "like-kind" property. Both the relinquished property and the replacement property must be considered like-kind to qualify for the tax deferral. In other words, if the investor is selling real estate, they must replace it with real estate, or it's not considered to be a like-kind exchange. They can't sell real estate and then buy something like a yacht and still qualify for the 1031.

The Role of an Accommodator in 1031 Exchange

Next is they must use a qualified intermediary, often called an "accommodator". The accommodator must comply with certain conditions. First, they must be arm's length to the transaction and not a party that is related, like an attorney or the real estate agent. Second, they must receive a fee for providing the 1031 exchange services. Third, they must receive the relinquished property from the investor and sell it to the buyer. And finally, they must purchase the replacement property from the seller and transfer it to the investor.

The Importance of Written Agreement in 1031 Exchange

Next, the 1031 exchange agreement must be in writing. 

The exchanger must inform the real estate agent about the 1031 exchange, and they need to make sure the process included in the purchase and sale agreement when listing the property for sale. The exchanger needs to make sure that the paperwork indicates that they're doing a 1031 exchange and the buyer will need to comply. 

It typically doesn't require any additional work for the buyer, except that they may need to sign off on certain, documents, such as assignments or disclosures. 

The property being sold is called the relinquished property. This is the property that's given up by the investor and also referred to as the "downleg" property. 

The property the exchanger buys is called the replacement property. It's also referred to as the purchase, the target property or the "upleg". 

Understanding the Timelines in 1031 Exchange

It's important to note that the timelines on the 1031 are strict. The identification period allows for a maximum of 45 days calendar days from the date that the relinquished property closes in its sale to when they identify the potential replacement property. And then the exchange period is 180 days total. That's the period of time in which the replacement property must be received by the investor. The exchange period ends either 180 calendar days after the relinquished property closes or the due date of the investor's tax return, whichever is earlier. However, there is a workaround for this. If the 180th day falls after the due date of the tax returns, then they may be able to file an extension, in order to utilize the full 180 day exchange period. 

The Process of Identifying Replacement Property

When executing a 1031 exchange, the exchangers should begin searching for a replacement property before closing on the sale of the relinquished property. The countdown to identifying the replacement property begins the day of the sale of the relinquished property, and that 45 days goes by fast. 

The exchanger needs to get through the offer, acceptance, and at the very least, the preliminary due diligence period of the potential replacement properties quickly, in order to reduce the risk of missing the deadline and losing the tax benefit of the exchange. So they should begin the replacement property search immediately. 

Avoiding 'Constructive Receipt' of Funds

The exchanger cannot take what's called "constructive receipt" of the funds. In other words, during this time, it's important that they do not receive any boot" and can be subject to capital gains tax.

" Cash boot" occurs when the exchanger takes any cash proceeds from the sale of the relinquished property, either by actual cash, or cash into a bank account that they control. The exchanger needs to acquire equal or greater replacement debt. Otherwise debt relief or mortgage boot is also a taxable event. 

Identifying Multiple Properties in 1031 Exchange

The exchanger can identify up to THREE properties. By midnight, on the 45th day, after closing the sale of the relinquished property, they must identify the potential replacement properties and submit the names of those properties to the accommodator in writing.

They can potentially identify even more than three properties, as long as they close on 95% of those, or a total combined value of the identified properties is less than 200% of the value of the relinquished property. That's a fairly complicated process. 

So the exchanger needs to be diligent and do their best to get a replacement property under contract as soon as possible.

Closing the Replacement Property Deal

When closing on the replacement property, the accommodator must transfer the funds to the title company or the attorney, and the property will close as a normal transaction. 

If all of the requirements of the exchange have been met, then this will defer the exchangers capital gains tax liability. 

The Power of Repeating 1031 Exchange

Finally, perhaps what's most valuable is that the 1031 exchange process can be repeated many times, and the exchanger can continue to defer their capital gains taxes indefinitely. When combined with the use of leverage, this can help the investor build significantly more wealth over time than they would be able to if they had to pay capital gains taxes each time.

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