Real Estate Investing: Closing in on 1031 Exchanges

With a booming real estate market for both sales and rentals, many investors seeking to diversify an income stream and find a tax-efficient asset are looking at direct investment into the asset class. Owning, managing and maintaining an investment property has a host of tax benefits, but there’s also one unique treatment they receive when it comes time to sell.

IRC Section 1031, commonly called a “like-kind” or “1031” exchange, provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. These gains are tax-deferred, but not tax-free – but you only pay the tax on the last property that is sold, not “exchanged.”

Building A Dynamic, Diversified Portfolio

Creating a real estate portfolio with growth potential that meets investors’ needs can often involve swapping out of assets – just like other forms of investing. The investor may want to leverage into more valuable real estate, shift to a different type of property usage to increase cash flow, create more geographical diversification, streamline management or even consolidate holdings. The 1031 exchange – which applies only to investment property – simplifies these changes by allowing the entire proceeds of the sale to be used towards the new property.

The Rules of the Exchange

The IRS defines like-kind property as properties that are of the same nature or character, even if they differ in grade or quality. Surprisingly, they’re fairly lenient on what qualifies as “like-kind.” As long as the real estate is being held for investment use, it’s possible to swap a piece of land for an industrial complex or an office building for an apartment complex.

One thing to watch out for is the value of both properties. If the new property has a lesser value than the one being sold, the difference may be subject to capital gains.

When looking to participate in a 1031 exchange, there are a few things to keep in mind. The transaction is similar to how someone would normally sell a home but with an additional person involved, also known as an intermediary. An intermediary steps in, takes the place of the seller, and holds the money the seller would typically receive from the buyer. This is because the transaction is an exchange rather than a sale so to keep it eligible, the seller is not allowed to touch the proceeds from the sale.

The IRS has also laid out a few timeframes that must be followed for a transaction to meet the Section 1031 requirements. The first one that must be followed is the 45-day rule. Within the 45-day window of sale, the seller must either close a new deal or locate a property and specify it in writing to be able to continue on with the 1031 exchange. Alternatively, the IRS states that if an investor doesn’t have the choices narrowed down yet, they can specify three different properties they’re looking to acquire as long as they close on one of them.

Next, the seller has 180 days from the time the property was sold to close on the new like-kind property. Going back to the intermediary, since they have the funds from the previous sale, they then acquire the replacement property and are able to transfer the new property to the original seller. The 1031 exchange is then complete and if all requirements were met, no capital gains would be due.

All properties must be in the U.S. to qualify. Additionally, primary residences, fix & flip projects, and vacation homes typically do not fall under the qualification for 1031 exchanges.

The Bottom Line

A 1031 exchange can be an effective strategy to not only defer capital gains, but to help diversify a portfolio with tax-efficient real estate transactions. However, the IRS has laid out rules that must be carefully followed. There are many moving parts and deadlines that must be made to ensure a transaction qualifies for the benefits of a 1031 exchange and working with an experienced advisor can help determine the necessary moves to make to keep the most money in your pocket.

The information contained herein is intended to be used for educational purposes only and is not exhaustive.  Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return.  If applicable, historical discussions and/or opinions are not predictive of future events.  The content is presented in good faith and has been drawn from sources believed to be reliable.  The content is not intended to be legal, tax or financial advice.  Please consult a legal, tax or financial professional for information specific to your individual situation.

This content not reviewed by FINRA