Real estate investing is arguably one of the best ways to build generational wealth over a long period. However, it can also be costly when you factor in taxes, upkeep, and other factors related to the industry. Nonetheless, it's not all bad, and specific schemes are in place to help alleviate some of the burdens.
One such option is the 1031 exchange. An investor can defer taxes on gains related to property sales with a 1031 exchange when done correctly. This can be a powerful tool for investors looking to expand their portfolios or enter new markets while retaining some liquidity throughout the process. This article will discuss this mechanism and how real estate investors can use it to their advantage.
What Is A 1031 Exchange?
Simply put, you can defer capital gains taxes by selling a property through a 1031 exchange process. This type of transaction enables you to defer paying taxes on the gain by reinvesting your proceeds in a similar or related property. However, to take advantage of this mechanism, you must find properties that meet specific identification requirements. To do so, you can use a dedicated 1031 exchange properties for sale page that provides a list of properties available to reinvest your capital gains. It is worth noting, however, that the tax postponement provided by a 1031 exchange is only valid if the sale proceeds are reinvested into a "similar" asset.
A 1031 exchange, therefore, allows investors to offset their capital gains taxes if the new property meets specific requirements. This is a huge boon for property investors looking to maximize their investments while minimizing taxes.
Who Can Benefit From A 1031 Exchange?
A 1031 exchange can be beneficial for investors looking to sell a property and purchase another without paying any capital gains taxes. It can also be used by an investor looking to buy and sell properties to diversify their portfolio and by real estate developers looking for a tax-deferred way of investing in different properties. Nevertheless, in order to participate in a 1031 exchange, you need to be the owner of an investment or business property. To be more specific, according to the IRS, it includes:
- Individuals
- C corporations
- S corporations
- Partnerships
- Limited liability companies (LLC)
- Trusts
In addition to owning a business or investment property, there are a number of other aspects to consider. First of all, not all investment properties qualify for 1031 exchanges. Rental properties, for example, must generate passive income in order to be eligible. Additionally, a 1031 exchange requires that the same individual own each property. Consequently, an investor cannot sell and buy rental properties under different LLCs.
How Does A 1031 Exchange Work?
While all of the above information sounds great, you may be wondering how they work so that you can reap the rewards. The process isn't as complicated as other tax deferrals and only requires five steps:
- Choose a property to sell: The obvious first step is to select a property you wish to trade. You should sell for a substantial capital gain if you want to gain from a 1031.
- Choose a property to buy: Ideally, you will already have a new property in mind, but if not, you should search for the one you believe will be a good investment.
- Make Sure All Properties Are Comparable: You must reinvest in like-kind properties in a 1031 exchange. Neither the quality nor grade of the subject properties matters, only that they are objectively similar. The IRS defines "like-kind" as an asset that is similar in nature to the relinquished asset.
- Partner With A Qualified Intermediary to facilitate the deal: To qualify for this tax deferral, you must use an intermediary to complete the transaction. An exchange facilitator must retain the sale's proceeds in an escrow account to avoid conflicts and fraud.
- Report the transaction to the IRS: The final step is informing the IRS when tax season rolls around. IRS form 8824 informs them of the deferral, which they can then implement.
Who Are Qualified Intermediaries?
Cash or other proceeds cannot be accessed before the exchange is completed in a deferred exchange or reverse exchange. Therefore, qualified intermediaries may hold the proceeds in escrow. A qualified intermediary cannot be:
- Yourself
- Your agent
- Any employee you have hired in the past two years
You can ask your attorney or real estate agent for a recommendation to find a qualified intermediary. It is vital to hire the correct intermediary so that you can reinvest your funds as soon as possible.
Reporting 1031 Exchanges To The IRS
As alluded to earlier, you will need to use an IRS Form 8824 to notify the IRS about your transaction. However, when filling out the form, you should keep records of everything related to the sale and purchase, including:
- Descriptions of the subject properties
- Transaction dates
- Details of parties involved
- Detailed records of money flow
The key to a successful 1031 (and all tax-related matters) is impeccable record keeping and timely IRS notification. In the event of failure to inform them promptly or suspicions of wrongdoing, you could find yourself with a dreaded audit with harsh ramifications.
Types Of Exchange
In order to take advantage of the 1031 deferral, you can perform three types of exchanges:
- Swap: When two properties are exchanged directly, this is called a swap. It's the most straightforward to operate.
- Deferred exchange: A deferred exchange occurs when the investor sells their property and then purchases a replacement after the fact. In almost all cases, an exchange facilitator is required to keep things transparent.
- Reverse exchange: When you acquire a replacement property through the titleholder of an exchange accommodation before identifying the replacement, this is called a reverse 1031 exchange.
Exchange Timeline
There are certain time limitations placed on a 1031. There is a limit on how long can pass between selling your first investment property and buying the second. After the sale of the relinquished property is closed, the taxpayer must identify their replacement property within 45 days or risk paying all taxes in one go. The taxpayer must also declare their replacement property within 180 days or risk paying all taxes due at once when they file their state income tax return for that year. The entire transaction will be disqualified if you take control of the proceeds before the deal has been completed, and all gains will be subject to immediate taxation. Depending on the nature of your transactions, you may even be held liable for penalties and interest, which can wipe out any gains you've made on the property.
Possible Downsides
Although a 1031 exchange is undoubtedly an excellent option for all real estate investors, there are some potential downsides you should be aware of.
1031 Exchange Trap
Aside from painful IRS penalties for inaccurate or incomplete filings, there is also something known as the 1031 exchange trap. Capital gains can be realized if an investor sells a property for a profit, then exchanges it, sells the following property, and exchanges it again, etc. Deferred gains can lead to significant tax liabilities after 10 or 15 years when the final asset is liquidated, possibly triggering capital gains taxes and depreciation recapture. Depreciation recapture is a technique in which the IRS collects income tax from a taxpayer who disposes of a property that previously offset their ordinary income with depreciation.
You Are Not Avoiding Or Reducing Your Tax Obligations
Since you are exchanging one similar asset for another, a 1031 exchange allows you to defer tax payments. In this situation, your cash flow will improve, but the gain from the sale of the new property will eventually have to be paid back in taxes. Nevertheless, this issue is somewhat mitigated by the fact that there is no time limit. Until you sell the property, you can defer paying tax.
Moreover, if you exchange like-kind properties and follow all the rules, you can do another 1031 exchange down the road and defer the tax again. In addition, you do not need to sell the property during your lifetime, and the property can be passed on to your heirs so that you do not have to worry about taxes (unless your heirs sell the property, in which case they will be responsible for it). Nonetheless, someone will eventually be responsible for paying for it.
The IRS Has Strict Guidelines Regarding What Is Classed As Like-Kind
Individuals promoting improper like-kind exchanges should be avoided, according to the IRS. For instance, some sales pitches claim vacation homes automatically qualify for 1031 exchanges. These pitches are easy to fall for, but without proper financial advice from a qualified intermediary, you could find yourself on the wrong end of the IRS.
1031 exchanges are an excellent way for real estate investors to defer tax made on capital gains from selling property by using the proceeds to purchase another similar one. However, you should never forget that you are deferring tax, not eliminating it. Nonetheless, as long as you understand the implications, a 1031 exchange is a great way to remain liquid when trading properties.
