Feature: Protect Your Investment with a 1031 Exchange
This post first appeared in the March edition of: Cirios Trends: In Search of Real Estate Opportunities.
Given the historic home price declines seen in the past four years, few investors have been focused on deferring taxes on real estate gains because, let’s face it, there just haven’t been many gains. However, as investors begin to wade back into the real estate market (cash investors accounted for more than 25% of existing home sales in January), they should be well-versed in State and Federal laws and tax codes that allow investors to minimize the pain of taxes.
One useful tool is the like-kind exchange created by 26 U.S.C. Section 1031 of the United States Internal Revenue Code. Or, as is more commonly known, the 1031 Exchange.
A 1031 Exchange allows an investor to sell an income, investment or business property and soon thereafter purchase, or “replace” it with a like-kind property, ie, another income, investment or business property of equal or greater value. All gains from the resale of the first property are deferred, so long as the IRS rules governing 1031 Exchanges are closely adhered to.
Several types of real estate properties can qualify for a 1031 Exchange. Real estate held for income, business purposes or investment can qualify, whereas personal residences and, for the most part, fix-and-flip properties do not qualify. Vacation homes and second homes that are not held as rentals also do not qualify, unless specific tests for “usage” set out in the IRS Code are met (consult a CPA or other expert before attempting a 1031 Exchange with a vacation home).
Today, most 1031 Exchanges are facilitated by what is known as a “Qualified Intermediary,” or QI. IRS rules are very strict about what can be done with sales proceeds that are to be rolled into another property in order to qualify for the 1031 Exchange, so QIs were designed to ensure all regulations are met for an approved exchange. The QI facilitates the transaction by acting as the investor’s agent when he or she sells the original property and buys the replacment. This is all above board, as regulators created this type of entity to try and standardize the process by which 1031 Exchanges could take place.
Upon the earlier of the deed recording or possession transferring to the new buyer, an investor seeking to do a 1031 Exchange has a non-extendable 45 days to close on or identify in writing a potential “Replacement Property.” After identifying this Replacement Property, the investor has a maximum of 180 days from the date the first property was transferred to the new owner to close the purchase of the Replacement Property. An important caveat: If the due date on the investor’s tax return for the tax year in which the original property was sold is earlier than the 180 day deadline, then the due date for the tax return is the final deadline for the closing of the new property.
If an investor fails to meet either the 45 day identification or 180 day closing deadlines, the 1031 Exchange is disqualified and taxes will be due on the capital gains from the sale of the property.
Once a Replacement Property is identified, the QI - not the investor - acquires the Replacement Property from the seller at closing. Once closed, the QI transfers the Replacement Property to the investor. This is done to ensure that 100% of the sales proceeds are rolled into the new investment and not used for any other purpose, which would disqualify the exchange.
Sound complicated? A bit. But 1031 Exchanges are a critical tool to building wealth in real estate by deferring tax obligations and using the savings to build more wealth. And, as always, investors should consult a CPA, attorney or other tax expert before attempting to perform a 1031 Exchange with your valuable investments.
DISCLAIMER: Cirios Real Estate is not a tax, financial or investment advisor. All investments carry risk. Before considering any investment options, including 1031 Exchanges, consult your investment advisor and tax professional.
Tags: 1031 exchange, real estate investing, real estate taxes