Deferring Tax Obligations: Understanding 1031 Exchange Rules
Real Estate investing is full of rules, especially when it comes to paying taxes on your properties. These rules and regulations can be confusing, but are also incredibly important to get the most from your real estate investments. With just a little investigation into the tax code, securities and exchange regulations, and property usage of those regulations, you may for example, be able to defer some or all of your taxes and increase your returns using the real estate 1031 exchange rules.
For example, if you own investment property apart from your primary residence or vacation home, you may be eligible to sell the investment and invest in another real estate asset while deferring capital gains tax. This is referred to as a like-kind exchange or 1031 exchange.
What is a 1031 Exchange?
At its most basic level, the IRS Section 1031 enables investors to defer potential taxes from a sale of one asset, and instead transfer the value from the sold asset (relinquished property) to another real estate asset (replacement property). The asset that is being acquired must be equal or greater in value than the one that is being relinquished. There are some nuances and formalities we will explain shortly, but the purpose of the quick turnaround is to defer capital gains taxes on the sale of the initial property. By reinvesting the proceeds from the sale into a new commercial real estate investment, the transferring of value from the relinquished property to the new investment is not seen as a taxable event.
There are however some qualifications for the properties a 1031 exchange real estate can be applied to. For starters the relinquished property may not be your primary place of residence. A property is considered a primary residence if you have lived there for more than two of the last five years. In order to execute a 1031 exchange on real estate, the replacement asset must also be of equal or greater value than the relinquished property. There are no restrictions however on exchanging between different types of properties, for example, selling land and buying an apartment building.
How does 1031 Exchange Real Estate Work?
The steps to setting up a 1031 tax exchange are not especially complicated, but they do feature some strict deadlines and restrictions. The first thing you will need to do is begin a relationship with a qualified intermediary or exchange accommodator. In order for the exchange to be valid the property holder may not receive cash or capital from the actual property sale, as it would then be considered a taxable event. Instead, the funds should be held in an account owned by a qualified intermediary between the time of the sale and the purchase of the replacement asset. This exchange accommodator will also facilitate paperwork and the replacement asset identification process.
The identification of your exchange properties comes with some tricky restrictions as well. In order to qualify tax deferred exchanges replacement assets must be identified in writing within 45 business days of when the property is sold. Investors can change the asset(s) within the 45 days, but after that the list final. There are three options for identify assets:
- Three Property Rule: Identify up to three replacement properties of any value that are planned to be purchased within 180 days from sale.
- 200% Rule: Identify an unlimited number of replacement properties that have an aggregate Fair Market Value (FMV) up to 200% of your relinquished property value.
- 95% Rule: Identify an unlimited number of replacement properties but must acquire 95% of the aggregate FMV identified
In addition to identifying replacement assets within 45 days, 1031 real estate exchanges also require investors to complete the purchase of those properties within 180 days. Again your qualified intermediary will assist you in these transaction. In cases where a replacement asset was acquired prior to the sale of the relinquished property, referred to as a reverse exchange, the investor must still sell the property within 180 days for the exchange to be valid.
Real Property and Personal Property Exchanges
So far in this article we have only referred to real estate exchanges, or real property 1031 exchanges. However real estate is not the only property that qualifies for 1031 exchange real estate deferments. It is also possible, though less common, to exchange personal properties. These exchanges are where the term “like-kind” is more applicable, as some commonality must be shown between the relinquished and replacement property.
Like-kind property is property that shares some nature, character or class. The quality or grade of the property is insignificant in its qualification for a 1031 exchange real estate allowance. For example, most real estate will be like-kind to other real estate. The restrictions on personal property however are more strict. Cars, for example, are not considered like-kind to trucks. It’s also worth noting the personal property will never be like kind to real property.
Why is a 1031 Real Estate Exchange Worth it?
If you’ve a savvy commercial real estate investor then the answer should be obvious. Money. Anytime the sale of an investment property results in a gain you have to pay a tax at the time of sale. A 1031 exception allows you to postpone paying that tax if you are able to prove it is being reinvested in an asset of a like-kind, in this case commercial real estate. While the transaction is not tax-free it is tax deferred, encouraging you to continue to scale your real estate investments and grow your portfolio.
CrowdStreet’s marketplace provides you with an simple and secure platform to browse, target and invest in real estate that may qualify for a 1031 exchange. If you are a commercial real estate investor interested in capitalizing on available properties contact us today to learn more.
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