Real estate owners and investors use the 1031 exchange as a way to build wealth by deferring the capital gains tax. For those unfamiliar, the IRS requires investors to pay taxes on the value of sold investments when that investment realizes a profit. Real estate and other investments are subject to capital gains taxes.
Named after IRS Section 1031, the exchange has many different variables. All investors must understand the ins and outs of Section 1031 before performing an exchange. It comes with many rules, such as the type of property and certain time frame restrictions.
Real estate investors can read this article for more information to learn various ways of how to get the most from their real estate investments.
Here are the rules regarding a 1031 exchange, so that you can invest intelligently.
Basically, a 1031 exchange works as a swap of one investment property for another one. One property owner sells their original property and then uses the money from the sale to purchase a replacement property. If and when you perform this swap correctly, you will have little to no taxes due at the time of exchange.
Essentially, the IRS sees these swaps as changing the form of investment without cashing out. This means you get a tax deferral on your investment while it keeps growing.
Section 1031 comes with no limits to how many times you can perform a 1031 exchange. You can use the exchange to keep rolling down your investments, continuing your swaps until you cash out way down the line. This means that instead of paying a short-term capital gains tax, you will pay the lower long-term capital gains tax rate.
While the 1031 comes with some limitations, you can get away with most exchanges. Section 1031 applies specifically to business and real estate property. This means that you must meet certain conditions to apply for an exchange to your primary residence.
First and foremost, both properties involved in the exchange must be located within the United States.
Beware when exchanging developed real estate for undeveloped land. This may trigger a depreciation recapture profit subject to taxation. Always rely on professional consultation when planning on performing a 1031 exchange to deal with this and similar complications.
The 1031 has undergone some changes and edits over the last few years. The Tax Cuts and Jobs Act of 2017 resulted in a tightening of the 1031’s application to solely apply to real estate. Before, one could exchange all sorts of personal property including vehicles.
Since 1031 exchanges occur for the purpose of deferring taxation, you must fully understand the concept of tax deferrals. Applied to investment earnings, a tax-deferred status allows investors to put off paying taxes until they take a constructive receipt of the profits.
Individual retirement accounts (IRAs) commonly receive the tax-deferred status. You can learn more about IRAs from our blog post here.
The deferral period differs depending on the type of investment. For a 1031 exchange, you can continue deferring paying taxes until you collect a full receipt from your sale. You can chain together various swaps indefinitely so long as you continue abiding by the rules of the exchange. You may even wait long enough not to have to pay any short-term capital gains taxes, and instead pay just the one long-term capital gains tax.
For investors, the ability to keep your funds available in their entirety keeps your investments active. Short-term capital gains taxes on any sold property would not allow you to sell a property quickly without paying heavy taxes on the gains.
Delayed Exchange Timing Laws
Most exchanges occur when two parties swap one property for another one. However, finding the right party to exchange with is not an easy or simple process. Therefore, most parties perform what is called a delayed exchange.
In order to perform a delayed exchange, a middleman must hold onto money after selling one property. They then use this money to buy the replacement property for their client. These kinds of three-party exchanges receive the same treatment as swaps.
The following timing rules require observation for the correct employment of a delayed exchange.
This rule correlates with the designation of a particular replacement property. After selling your first property, you must provide designation in writing to your middleman regarding the replacement property your wish to purchase.
The IRS allows you to choose up to three different properties at this designation stage. However, you must eventually close on one of these three properties. In certain circumstances, you may be able to designate additional properties.
Now that you have designated your properties, you have 180 days since the sale of the old property to purchase the new one. The 180-day rule runs concurrently with the 45-day rule. So if you wait 40 days to designate your replacement properties, you have 140 days left to close on one of them.
Reverse 1031 Exchange
A reverse exchange occurs when you acquire a piece of replacement property before selling your original property. This allows buyers to work with the restraints of the real estate market and make a purchase when the opportunity arises. In this case, you may wait for the value of your old property to increase before selling it.
This would mean that you can buy a replacement property at a lower price and then sell your original property at a higher price.
Reverse exchanges function in a similar fashion as regular 1031 exchanges. They allow an investor to defer paying capital gains taxes upon selling an investment property. Investors generally have 180 days to sell their original property after purchasing replacement property to make good on the reverse exchange.
Crucially, the purchaser must have the financial capabilities to make the purchase. This means that they must provide the entirety of the sum of the new property upon purchase. You may work with a lender, but not every lender or financial institution will work with an investor performing a reverse exchange.
Dealing with Gains and Debt
Once you have your middleman acquire the new property for you, you may end up with cash from a gain. The middleman will give you any excess cash from the sale once it concludes. Called “boot,” you will owe taxes on this cash as a capital gain.
For example, if you sell a property for $500,000 but purchase a new one for $400,000, your $100,00 gain will get taxed.
Make sure you keep all loans and debt from either the sold property or the purchased property accounted for. In the event that you do not receive any cash gain from your sale but your overall liability goes down it gets treated as income.
Many investors may wish to apply the 1031 provision to renting out vacation homes prior to swapping them. Before 2004, many loopholes allowed many property owners to do this without a problem. However, Congress now requires that tenants actually occupy the property, while before simply offering it as a rental space sufficed.
So long as you rent the property out to tenants for at least six months, you can swap the property without a problem. Down the line, you can eventually transfer your permanent residence to these properties. Many property owners buy these kinds of vacation homes on a swap, rent them out for a few years and finally move in once they retire.
Retiring without a mortgage could help you really soak in your retirement years. Learn more about retiring mortgage-free from this article here.
Moving into a Swapped Residence
Investors and non-investors alike may wish to use the property they swapped for as their primary residence. However, you cannot make it your residence immediately after completing the exchange. The IRS created a new safe harbor rule in 2008 saying that the organization would not challenge the qualifications of the investment property subjected to a 1031 exchange.
In order to meet the safe harbor requirements, the IRS requires that you rent the property to another person in a fair rental for at least 14 days. Additionally, you cannot use the property for more than 14 days or 10 percent of the number of days the property is said to be a fair rental during a 12 month period.
So basically, you cannot make the newly swapper for property your primary residence immediately. You must wait five years since acquiring the property in a 1031 exchange before selling it as your primary residence.
Proper Investments Need Proper Advice
No matter the kind of investment you plan to secure, you need a trusted financial planner to help navigate through all of the details. Here at NextGen Wealth, we have the expertise to guide you.
Our founder Clint Haynes began his journey as a financial planner twenty years ago. You can count on that experience to help you make the right choices.Take our free Retirement Readiness Quiz today to see how you are doing on your own financial journey or simply click here for more information on how to reach out and begin planning for your future.