Savvy investors can build wealth by deferring capital gains taxes via a 1031 exchange. This article highlights what that is, how it works, and how it can help you as a real estate investor. For the in-depth information required to execute a 1031 exchange, a qualified intermediary is necessary.
What is a 1031 Exchange?
A 1031 exchange allows real estate investors to avoid paying capital gains taxes when selling an investment property and reinvesting in a replacement property. The name 1031 exchange comes from Section 1031 of the U.S. Internal Revenue Code.
A 1031 is also called a like-kind exchange. It is essentially a swap of one investment property for another. The “like-kind” refers to the fact that the properties in the exchange must be similar (i.e., of like kind) and the exchange property must be of equal or greater value as the property sold.
How Does a 1031 Exchange Work?
Under IRS code section 1031, which applies to real estate, investors can reinvest proceeds from the sale of one property into another property within a specified time frame to avoid paying capital gains taxes (the taxes on the growth of an investment when it is sold). Because it is rare for an even property swap to occur between parties, the most common type of exchange is the delayed “forward” exchange. In this case, the sold property funds are sent to a qualified intermediary and later used to acquire a replacement property from a seller.
What is a Qualified Intermediary?
A qualified intermediary facilitates a 1031 exchange. They hold the transaction funds from the sale of the first property until those funds are transferred to the seller of a replacement property. The qualified intermediary also prepares the legal documents required for the exchange. The qualified intermediary can have no formal relationship with the exchange parties outside of the exchange.
1031 Exchange Important Deadlines
- The seller of the first property (the relinquished property) must identify a replacement property (their new investment property) within 45 days of the transfer of the relinquished property.
- The replacement property must be received by the exchanger within either (1) 180 days of the date the exchanger transferred the first Relinquished Property or (2) the due date of the exchanger’s tax return for the year that the transfer of the first relinquished property occurs.
- These are strict timelines and are not extended even if the 45th or 180th days fall on a weekend or holiday.
What You Need to Know about a 1031 Exchange
1031 exchange transactions should be handled by a professional qualified intermediary that is a third party (i.e., not a family member, friend, acquaintance, or business associate of either party involved in the exchange).
Exceptions
The IRS does not allow capital gains tax avoidance if the exchange:
- is U.S. real estate for real estate in another country
- involves property for personal use
- is between related parties and either disposes of the property within two years
Why Do Investors Use a 1031 Exchange?
- They can use what they would have paid in capital gains taxes to put more down on a replacement property to improve their buying power.
- The savings on federal capital gains taxes could be 15 to 20 percent.
- There could be savings at the state level (this varies by state, so your qualified intermediary should be consulted for this information).
- The amount of income taxes paid could be reduced due to depreciation of the investment property.
A 1031 exchange is a tool that savvy real estate investors use to build wealth over time. To further understand how a 1031 exchange can benefit you, ask your CPA or accountant to help put you in touch with a qualified intermediary. Their guidance is critical in executing a 1031 whether you’re swapping two properties or working with a full portfolio of investment real estate properties.