1031 Exchange Rules

One of the most important aspects of successful real estate investing involves knowing how to take advantage of the legal tax breaks afforded to real estate investors. Knowing how to use all of your resources, including legal tax breaks, is not only an important part of making as much money as possible from your investments, but it also helps you build a reputation of competency with others in the investment arena.

One of the most powerful tools that investors have at their disposal is a 1031 exchange. This option is designed to let investors sell one property while adding another to their portfolio without being responsible for the capital gains taxes associated with the sale of the first property. Understanding the rules about how to use a 1031 exchange is a vital component of finding success in the always competitive real estate investing industry.

What is a 1031 Exchange?

Under federal guidelines, a 1031 exchange is the financial exchange of like-kind properties. Many investors, especially those who are new to the industry, assume that this rule means that they have to buy a property that is exactly like the one they sold. For instance, some investors incorrectly assume that if they sell an apartment complex, they can only use the funds generated to purchase another apartment complex under the rules of a 1031 exchange. That is simply not the case.

Under a 1031 exchange, you can use the proceeds generated by the sell of your first property to purchase another property. While most real estate transactions trigger what is known as a “capital gains tax,” investors defer that tax by purchasing a replacement property. They do not owe taxes on the sell of the first property until they liquidate a property without purchasing a new one.

The term “like-kind property” generally refers to any sort of income-generating property. However, there are some other rules that investors must follow when utilizing a 1031 exchange.

The Use of an Intermediary

It’s important to realize that a 1031 exchange is not a solo project. Instead, the IRS requires that real estate investors work with a qualified intermediary, often referred to as a QI, in order to facilitate the sell of one property and the purchase of another. When you sell a property, the qualified intermediary that you’re working with receives the funds. Then, when you choose a property to buy with those funds, it is the qualified intermediary who releases the funds to be used. While this may seem like an unnecessary step, it’s quite useful. Not only does it provide you with an added layer of security to ensure that there are no accusations of misusing the funds, but this QI can also help ensure that you’re purchasing a like-kind property.

The 45-Day Rule

One of the most important aspects of 1031 exchanges involves the time in which you must declare your replacement property. Within 45 days of the closing date of the property that you’ve sold, you must provide a written declaration to your qualified intermediary with the information about the property that you intend to purchase with those funds. Per current IRS guidelines, investors can declare up to three properties in this written declaration as long as they close on one of them within the 45-day window.

The 180-Day Rule

In addition to declaring the property that you plan to buy within 45 days, you must also close on it within 180 days of the sale of the old property. With this rule in mind, it’s important to be prepared to act quickly after selling the first property. There are any number of issues that can come up resulting in a delayed closing, and failing to close within 180 days of the first property being sold means that cannot utilize the 1031 exchange.

What About Leftover Cash?

One of the most frequently asked questions about the use of a 1031 exchange involves any cash that is left over after the new property has been purchased. There is nothing in the current Federal Tax Code that requires you to spend all the money that you made from the sell of your first property. However, the federal government will expect you to pay income taxes on the money that you don’t use to purchase the second property. This money, often referred to as “boot” is taxed at a discounted rate than most capital gains, but must be reported on your annual tax return.

A Hypothetical 1031 Exchange

Now that you have a working knowledge of the rules surrounding a 1031 exchange, let’s look at a hypothetical example so we can put these rules into practice.

Part of your investment portfolio involves Property A, which is a multifamily apartment complex. You sell the property to another investor for $500,000. You and the buyer close on their purchase of the property on May 1, and your intermediary receives the funds since you have already let them know that you will be using the money to purchase another investment property.

On May 31, you provide a written declaration of intent to purchase to your intermediary for Property B. Since you have provided your written declaration on day 30, you are within the allowable 45-day window.

Since you have already selected Property B, which will be your replacement for Property A, you are able to close on it on September 1, only 93 days after you closed your sale of the first property. This means that you have closed on the replacement property within the 180-day period allowed to investors. You only spend $450,000 on Property B, which is a duplex. The $50,000 that are left over after the purchase are taxed at a discounted rate.

There are no limits regarding how many times you can exchange properties, so hypothetically, you could continue to purchase properties with the income generated by the sell of Property B.

Not only should you work with a qualified intermediary to ensure that you’re operating legally, but it’s also a good idea to employ the services of a real estate attorney and a tax professional. The real estate investing industry can certainly be very lucrative, but it’s important that you follow each and every rule set forth by the IRS.