A 1031 exchange derives its name from Section 1031 of the U.S. Internal Revenue Code. It allows real estate investors to defer payment of taxes on any capital gains that they would normally have had to pay during the sale.
Essentially, a 1031 exchange can enable a real estate investor to save as much as 30% in combined state and federal taxes.
Thinking of swapping your Georgia property for another and want to defer capital gains? If so, here’s everything you need to know about 1031 exchanges.
Is a 1031 exchange really that important?
A 1031 exchange can be an incredible tool for real estate investors looking to build wealth. Below is an illustration of how you might be able to do that.
Now, suppose you bought a piece of real estate for $100,000 5- or so years ago. And luckily for you, you’ve found a buyer who is looking to buy it for $500,000. Naturally, as per the Internal Revenue Code, you’d be subject to paying capital gains on the profit ($400,000).
And typically, the taxes due on that profit would be about 30%. So, that means that you’d lose about $120,000 in capital gains taxes.
However, here’s the thing. With a 1031 exchange, you’d be able to make use of the entire $500,000 to buy at least one property and pay zero taxes. The new investment(s) would then generate more cash flow and appreciate in value.
Of course, you’ll eventually have to pay taxes when you sell that property. In the meantime, though, you may be able to make your money go further through a 1031 exchange.
1031 Exchange Requirements
For an investor to qualify for a tax deferment, certain key requirements must be satisfied.
To begin with, the properties must be exchanged. By itself, a sale that precedes a purchase cannot qualify as a 1031 exchange. Rather, a transaction must be treated as an exchange for the purposes of deferring taxes.
A qualified intermediary is necessary in a 1031 exchange. They act as a middleman to tie a sale to a buyer and the purchase from a seller.
Secondly, the properties being swapped must be held for investment or business purposes. You cannot, for instance, exchange a land for a residential property that you live in.
Thirdly, both the relinquished property and the replacement property must be “like-kind.” “Like-kind” refers to the nature of the investment. They are similar real estate assets that are exchangeable without incurring any tax liability as per the Internal Tax Code’s Section 1031.
The following are property exchanges that could qualify under the Code:
- An office building for a ranch or farm
- An apartment building for an industrial building
- Raw land for an industrial building
- An office for a shopping center
The following is a list of properties that wouldn’t qualify for a 1031 exchange:
- A fix-and-flip property
- A personal residence
- Land meant for resale
- Second homes
Lastly, to potentially defer all capital gains, you must reinvest all equity. In other words, the replacement property must be of equal or more value than the relinquished property.
Types of Like-Kind Exchanges
Broadly speaking, there are three kinds of like-kind exchanges: delayed exchange, build-to-suit exchange, and reverse exchange.
This is an exchange that occurs within 180 days. It’s the common type of 1031 exchange, and requires that the sale of the relinquished property followed by the acquisition of replacement property be done within a 180 days’ period.
This is a type of exchange that allows time for the replacement property to be newly constructed or renovated. And like delayed exchanges, the construction or renovation must be done within 180 days. Any improvements made after the 180 days elapse won’t qualify for a 1031 exchange.
This is the opposite of a reverse exchange. Wherein, the replacement property is acquired first, and then the existing one is sold. This type of exchange was created in order to help buyers buy a new property prior to being forced to relinquish their current property.
Time Limits & Identification Requirement
Delayed Exchange (Forward 1031 Exchange)
Once you relinquish a property, you’ll have 45 days to identify or acquire a replacement property. You can identify up to 3 replacement properties. And while this may sound easy, it usually isn’t – particularly in a seller’s market.
Next, you must buy any of the properties (up to 3) you identified within a period of 180 days.
Let’s take an example. Suppose you are looking to sell a piece of real estate and wish to defer payment of capital gains. So, if you relinquish a property on May 1st, then you will have up to June 15th (within 45 days) to identify a replacement property.
Next, you’ll need to close on the replacement property by October 27th of that same year (within 180 days after relinquishing your property).
If all these timelines are met and the properties are like-kind, then a 1031 exchange will be possible.
Similar to a delayed exchange, there are certain timing and documentation requirements needed to make a reverse exchange valid.
First, you’ll need to acquire the replacement property before selling the property you have relinquished. That said, you’ll only be able to take full ownership rights to the acquired property once the 1031 transaction is complete.
In the meantime, the property you’ve acquired will be in the hands of the Exchange Accommodation Titleholder (EAT) until the property that’s relinquished is sold.
Lastly, you must close on the sale of the relinquished property within 180 days after the EAT takes title of the replacement property.
This is the difference in value between the relinquished property and then one replacing it. Boot is taxable.
Here’s an illustration of how boot can occur.
Supposing you are selling a property for $400,000 and buying a replacement one for $320,000. As per the IRC, this transaction would be a partial exchange, as the value of the relinquished property exceeds that of the replacement property.
The difference ($80,000) becomes the cash boot and is taxable.
Building wealth is every Georgia real estate investor’s dream, and a 1031 exchange offers a quick way to achieve it. Use this guide to help you make huge tax savings on your next real estate transaction. If you find the process intimidating, there is always the option of having expert help by hiring Haas Properties. Contact us today!