The term 1031 exchange comes from section 1031 of the IRS code. It is a way to exchange your investment property for another investment property and defer capital gains taxes. There are four types of exchanges: simultaneous exchange, delayed exchange, reverse exchange and construction/improvement exchange. The delayed exchange is by far the most common type of exchange.
A common scenario in a 1031 exchange is this: An investor owns 3 rental houses that are old and require a lot of maintenance. The investor decides to sell the rental houses since the profit margins are dwindling. He would like to purchase and use a multifamily property as an investment. A 1031 exchange would be the best way to do this so that the tax bill does not overwhelm whatever gains he has made on his current properties.
A 1031 exchange is a rather complicated process with strict guidelines, but it can be of great benefit in the right situations. The first rule is that you must be exchanging “like-kind property”. This does not necessarily mean that a rental house can only be exchanged with another rental house. As in the scenario mentioned above, you can exchange multiple properties for a larger property and vice-versa. Like-kind generally refers to the investment property aspect of real estate. You must be exchanging an investment property for an investment property. Personal property is not allowed to be used in any part of the exchange.
Also related to the like-kind aspect of the exchange, the properties must be of the same value. If you sell your property for $1 million, you must buy $1 million worth of property in exchange. If the property that you purchase falls short of the sale price, the taxes will not be deferred for the profit portion, sometimes referred to as the “boot”. For example, if you sold your property for $1 million, and bought property that cost $800,000, you would be responsible for capital gains taxes on the $200,000 boot.
The last big part of the exchange rules are the timeline requirements. You have 45 days from the day you sell your property to identify the property that you will purchase in the exchange. Then you have a 180 day purchase window. The purchase transaction must be complete no later than 180 days from the date of the sale.
1031 exchanges can be a great tool but it is important that you have a game plan in place and that you work with professionals qualified to engage in these transactions. An experienced real estate agent is a great place to start and Lisamarie Wand is available to answer any questions you may have.