|- What is a 1031 Exchange?
According to section 1031 of the Internal Revenue Code, a titleholder may exchange like kind property tax-deferred through a process called a 1031 Exchange. In order for this to be done properly, the titleholder needs to go through a Qualified Intermediary and follow these 6 IRS Rules:
- 180-Day Exchange Closing Period
From the date of closing on the sale of the old relinquished property, you will have 180 days to close, or get into title, on a new replacement property. The new property you purchase must be listed on your 45-day form.
- Qualified Intermediary
The IRS mandates that you use a QI to hold your cash proceeds from the sale of your old property and prepare the legal documents for your exchange. Your QI must be an independent third party, and cannot be a friend, employee, broker, or even your CPA or Attorney. Your QI will then forward those cash proceeds to the closing agent of the new property when you purchase in your 1031 exchange.
- Proper Title Holding
You must purchase and hold title to the new property exactly as you held title to the old. In other words, whoever the taxpayer was that sold the old property must be the same taxpayer to buy the new one.
- Reinvestment Requirement
In order to defer all of your capital gains tax, you must reinvest all the cash proceeds from the sale to buy a new property equal or higher in value than the one you sold.
- Is a 1031 Exchange tax free?
Not exactly. A 1031 exchange is tax deferred, meaning you are delaying the payment of the taxes until another time. There are two ways that you can make the 1031 exchange tax free: 1) You hold onto the replacement property until you die, or 2) You roll over your replacement property into another 1031 exchange, and continue to defer taxes. Essentially, you can continue to do this until you die. Should you sell your replacement property outside of a 1031 exchange, the taxes that were deferred will then need to be paid off.
- How do I choose a Qualified Intermediary?
This is an important question, as your QI will be the person preparing your legal documents for the exchange, and holding your money during the exchange period. Qualified intermediaries are not regulated by the government, so you will want to make sure that you find one who you can trust. We suggest finding a QI who is bonded and insured. Here at 1031 Exchange connection, we are bonded and insured, have close relationships with our local banks where the funds are held, and keep all of our client’s exchange funds in separate, non-comingled accounts. The banks we use are thoroughly researched for the safety and security of your funds.
- What does like kind property mean?
In a 1031 Exchange, an investor exchanges for a like kind property. Like kind means both the old property you are selling and the new one you are buying must be “held for investment”, or used in a trade or business. Rental property is always considered trade or business to the IRS, so clearly rental property qualifies. Land also is considered held for investment as land “appreciates”. A common misperception about 1031 exchanges is that it does not mean the properties need to be zoned exactly the same (i.e. if you are selling a piece of land, you don't have to purchase just a piece of land). Rather, it refers to the use of the property. Therefore, in a 1031 property exchange, both the old and new property should be held for investment or used in a trade or business to qualify.
- Does my property qualify for a 1031 Exchange?
In a 1031 property exchange, your property should be held for investment, or income producing. Some examples of this would be:
- A building that is used for a business or trade
- A property that is rented for 14 or more days per year at fair market value
- A piece of land held for investment
Not all property qualifies for a 1031 Exchange. Here are some properties that won’t qualify for exchange:
- Your principal, or homesteaded, residence.
- A second home that is not income producing (no renters).
- A property strictly held for resale (used as a “flip”). The IRS frowns upon this, so as a general rule we tell clients to hold onto their investment property for a year and a day.
Example 1: Jim and Sue own a beach condo in Florida. They use it for their personal vacation two months out of the year, but rent it out to others for the rest of the 10 months. They would like to do a 1031 Exchange and purchase a log cabin in the mountains of Asheville, NC to continue to use for vacation, but also rent out other times of the year. Would these properties qualify for a 1031 Exchange?
Yes. The old property was held for investment, and the intent of the new property is also for investment, so this would qualify Jim and Sue for a 1031 Exchange.
Example 2: Ron bought a home, made some renovations, and is now selling it only 2 months later. He would like to do a 1031 Exchange and purchase another home. Does he qualify?
No. In this situation, the intent of his property is held for resale, which would not qualify for a 1031. However, if Ron decides to rent it out and hold onto it for another year or two, he can then do a 1031 Exchange.
- How long should I hold my investment property to qualify for a 1031 Exchange?
As general rule, we advise that you hold investment property for a year and a day to show that it is held for investment. What the IRS will look for is intent—was the property purchased with the intent of being held for investment? This is why a “flip” would not qualify. Holding a property for a year and a day or more will demonstrate to the IRS that your intent was to hold the property for long-term investment. While this is a general rule we typically tell our clients, everyone’s situation is different. Please contact us if you are unsure if your property would qualify as being held for investment.
- What are the time requirements in a 1031 Exchange?
- The time to get a hold of us to start the 1031 Exchange process is before the closing of your relinquished property. Legal documentation will be written and given to all parties involved notifying that the sale of the property is part of a 1031 exchange. In addition, arrangements need to be made so that we obtain the rights to receive your cash proceeds from your sale prior to closing. The clock of your 1031 Exchange will start on the day you close on your relinquished property.
- From the day of closing on the relinquished property, you have 45 days to identify up to 3 properties that you would like to purchase as your replacement property. You must purchase at least one property from this list. If the property is not listed on your 45-day form, it cannot be purchased in the exchange.
- Also from the day of closing on the relinquished property, you have 180 days to close on the replacement property that was properly identified on your 45-day list. The 180 days begins at the day of closing on the relinquished property too, not after the 45-day list is complete.
- Can foreign property be exchanged for US property?
No, U.S. property must be exchanged for U.S. property. However, a foreign investor may do 1031 exchange if both the old and new are U.S. real property interests.
- What is capital gains tax?
When there is a sale, the government sees this as a taxable event. Capital gains tax is tax on the profit from the sale of a property or investment. For example, let’s say you purchased a property $300,000. A few years later, you sell it for $500,000, or a $200,000 capital gain. You will now be taxed on the capital gain, as well as the depreciation recapture if the property was a rental. In this example, that could end up costing you about $50,000 (average tax rate 25%), perhaps more depending if you live in a taxable state. This why you do a 1031 exchange!
- I would like to do a 1031 exchange, but I would like to buy the replacement property before the sale of the old property. Is this possible?
The answer is yes! A Reverse 1031 Exchange allows the exchanger to acquire their like kind replacement property first, then sell their old relinquished property within the guidelines of a 1031 Exchange. The issue with the IRS is they will not allow you to hold title to both the old and new properties at the same time during a 1031 exchange, as by their very own definition that would disqualify the exchange.
The IRS issued a ruling (revenue procedure 2000-37, a “Safe Harbor”) which allows your Qualified Intermediary to take title to your new property first and hold it until the old one sells. As Qualified Intermediaries, we create an Exchange Accommodator Titleholder (EAT) to take title to your new property (usually in an LLC), and we “park” it there until the old property is sold. This is how the IRS allows you to only hold title to the new property without turning your exchange into “toast”.
Once your Qualified Intermediary has taken title to the new property, you have 45 days to identify the property you want to sell, 180 days to sell it, and then get into title to the new property the QI is holding for you. Obviously with this type of arrangement you are going to have lots of questions and will need to know how the QI will protect you during the time we are holding the property for you, so give us a call and we will be happy to explain how we work these, as well as keep you safe during the reverse 1031 exchange period.
- What Is a Construction Exchange?
A construction exchange allows you to sell your old property and use that money to buy a piece of bare land and build a building on it. This situation arises when the seller is a land or lot owner, or perhaps a builder or developer who requires you to buy, or take title to, your land first before you or they start construction. If this is your situation, then the construction exchange would fit your bill. See our section on “Construction 1031 Exchange” to learn more about this valuable tool to use when you want to construct new property for your replacement property.
- Can I buy new construction from a developer in a 1031 exchange?
If you are considering buying new construction from a builder or developer, such as a WCI Communities, Lennar, DR Horton, and they require you to enter into a contract to start on construction with them, remember that you only have 180 days from the date you sold your old property to get in title to the new one. Also note that this is not a “construction exchange” explained earlier because you do not need to take title to the land with this type of developer. In essence, you are just entering into a contract to buy replacement property, with the caveat that what you are buying needs to be built first before you can take title to it. At the same time, you need to keep in mind that developers make no guarantees they will finish construction within the 180 day time frame of a 1031 exchange, but they will promise you the world to get you to contract with them. In these cases, we recommend you place at least two (2) more properties on your 45 day ID form in addition to the one being constructed just in case the new one will not be ready in time. In this manner you may have a better chance of completing your exchange if the construction is not completed by day 180. However if you have your heart set on a property in a new development, try to get firm assurances written into the contract that the developer will commit to that will guarantee you get in title by day 180.
Another way to work with a developer and new construction is to buy one of their models, and then lease it back to them. We like this strategy because you should be able to buy right away and get in title by day 180, and then earn cash flow from them while they show their models to prospective buyers. In this manner you satisfy the “held for investment” requirement in a 1031 exchange as well. In addition, developers typically keep their models impeccably clean during the model period, assuring you will get your property in great shape by the time they turn it over to you. Also, many developers build on “spec”. Try to buy one of their spec homes as those have a much better chance of being completed by day 180. Otherwise, if day 180 comes and construction is not finished, your exchange has a good chance of becoming toast.
Can I file my tax return before closing out the exchange?
If you find yourself in the middle of an exchange and you are preparing your tax returns, you better think twice. In what we like to call the “extension trap,” a taxpayer may decide to file their taxes after the sale of their relinquished property and before the closing on the replacement property. Think about it—if you were to do this, all that the IRS would see is you sold a property during that year. There would be no documentation yet to show that you were in the process of doing a 1031 exchange. So, what would happen? The IRS would see you sold a property, tax you on the sale of it, and your exchange is toast. Even worse, the IRS will not let you amend your tax return to recapture the 1031 exchange. The solution to this would be to talk to your accountant or 1031 exchange consultant to see if filing for an extension on your tax return is necessary to avoid accidentally toasting your exchange during tax season.