Savvy investors know that when planning the sale of an investment property, they can defer capital gains tax, and therefore, maximize profits, by facilitating a 1031 exchange.
Capital gains tax refers to the fee that the United States government imposes on the profit from the successful sale of certain assets, including real estate. In this case, your capital gain is calculated based on the total sales price minus the original cost of the property.
You incur capital loss when you sell property for less than its original price. Capital losses can offset capital gains on your annual tax return, which lowers the amount you pay in taxes.
Doing a tax-deferred exchange also allows you to sell investment property and replace it with similar or “like-kind” property. The 1031 exchange is widely touted as a wealth-building tool that property investors should leverage when offloading property.The R&Z Group of Marcus & Millichap has multiple 1031 exchange accommodators for clients to choose from to help make the process as smooth as possible
So how does a 1031 exchange work? Read on to find out.
More on the 1031 exchange
The 1031 exchange is an excellent tax strategy for property investors. With a 1031 exchange, the capital gains tax on a sale can be deferred, or postponed, for as long as the rules of the Internal Revenue Service (IRS) are followed closely. If done right, you can theoretically continue to defer capital gains until your death, allowing you to avoid capital gains tax on the sale altogether.
Named for Section 1031 under the Internal Revenue Code, a 1031 exchange covers real estate properties held for business or investment purposes.
For a transaction to qualify as a 1031 exchange, it must take the form of a swap rather than the sale of a property followed by the purchase of a like-kind property.
Moreover, the replacement property must have also been held for trade, business, and investment purposes.
Criteria for eligible and like-kind properties
Before Congress passed Section 1031(a) in 1984, which imposed limits on deferred exchanges and provided a clearer definition for like-kind property, investors took the term “like-kind” quite literally – for example, if an investor wanted to sell a three-story apartment building through a 1031 exchange, they took pains to find another three-story apartment building with an owner who was willing to do a swap.
These days, you can swap an apartment building for vacant land or a warehouse.
Property swaps that fit the criteria for a modern 1031 exchange include:
- A corner office for a strip mall
- A strip mall for a vacant lot
- An apartment community for an industrial property
- A single-family home rental for tenants-in-common (TIC) property
The following properties don’t qualify for a 1031 exchange:
- Personal residences
- Fix-and-flip properties
- Vacation/second homes that are not being used as rentals
- Properties that have been purchased for resale
- Land under development
Stocks, notes, bonds, inventory property, beneficial interest, and similar investments don’t qualify as “like-kind” property for purposes of exchange.
To determine whether your property or intended swap qualifies for a tax-deferred exchange, consult a tax expert.
The passing of 1031(a) in 1984 also established a strict timetable for the completion of an exchange. This timetable must be followed if you are to avoid tax consequences.
CONTACT THE R&Z GROUP OF MARCUS & MILLICHAP FOR A DETAILED STRATEGY THAT WE OFTEN UTILIZE TO MITIGATE THE RISK OF THESE TIMELINES AND EVEN EXTEND THEM!
Property investors have 45 days to identify or close on a potential Replacement Property, which must be done in writing, after closing the sale and transfer of the Relinquished Property.
This 45-day window includes holidays and weekends, and is non-negotiable. Going past the time limit will disqualify the swap from being recognized as a tax-deferred exchange, and taxes will be imposed on the investor.
The following properties may be identified as Replacement Properties during this time period:
- Three (3) real estate properties regardless of fair market value (FMV); or
- Any number of eligible business or investment properties whose aggregate FMV does not exceed 200% of the aggregate FMV of the relinquished property at the end of the identification period, and as of the transfer date
If you fail to meet the three-property or 200% aggregate FMV rule, the exchange can still go through if you purchase 95% of the aggregate FMV of all the properties chosen during the identification period.
Once you’ve identified a satisfactory replacement property, you’ll have 180 days from the date of transfer of the Relinquished Property to close the deal.
Mind the due date on your tax return for the tax year in which the Relinquished Property got sold – if it is set before the end of 180 days, then the 1031 exchange must be completed at an earlier date.
Part of this 180-day period will have already been used during Identification, so it is generally advisable to close on the Replacement Property before the deadline.