If you’re currently an owner of an investment property, a 1031 exchange might be the ideal real estate transaction for you if you want to purchase another property while selling off your current one. A 1031 exchange is a tax-deferred exchange that allows you to defer capital gains taxes as long as you are purchasing another “like-kind” property. This exchange mechanism is used by some of the most successful real estate investors and can be beneficial in a variety of situations. The following is a general guide to a 1031 exchange in California. It includes details about what the 1031 exchange is, how to perform the exchange, and why the exchange could be beneficial for you. Understanding the intricate details of a 1031 exchange should be accomplished using a “Qualified Intermediary” which is a professional third-party company that accommodates the exchange process and helps you avoid making any critical mistakes that could jeopardize your tax-advantaged sale.
What Is a 1031 Exchange?
A 1031 exchange is an exchange that occurs when you sell one investment property in order to purchase another. When swapping your current investment property for another, you would typically be required to pay a significant amount of capital gain taxes. However, if this transaction qualifies as a 1031 exchange, you can defer these taxes indefinitely. This allows investors the opportunity to move into a different class of real estate and/or shift their focus into a new area without getting hit with a large tax burden.
The main requirements for a 1031 exchange are: (1) must purchase another “like-kind” investment property; (2) replacement property must be of equal or greater value; (3) must invest all of the proceeds from the sale (cannot receive any “boot”); (4) must be the same title holder and taxpayer; (5) must identify new property within 45 days; and (6) must purchase new property within 180 days.
To understand how beneficial a 1031 exchange can be, you should know what the capital gains tax is. In most real estate transactions where you own investment property for more than one year, you will be required to pay a capital gains tax. This directly levies a tax on the difference between the adjusted purchase price (initial price plus improvement costs, other related costs, and factoring out depreciation) and the sales price of the property. The percentage that’s taxed on your capital gains depends on the tax bracket that you’re in. The 1031 exchange is defined under section 1031 of the IRS code, which is where it gets its name.
4 Types of Real Estate Exchanges
There are four types of real estate exchanges that you can consider when you wish to participate in a 1031 exchange, which includes:
- Simultaneous exchange
- Delayed exchange
- Reverse exchange
- Construction or improvement exchange
1. Simultaneous Exchange
One type of 1031 exchange is a simultaneous exchange, which takes place when the property that you’re selling and the property that you’re acquiring close the same day as one another. Keep in mind that this exchange must be simultaneous in order for you to receive the benefits. If the closing of either property is delayed for a short period of time, the exchange could be disqualified, which means that you would need to pay full capital gains taxes.
A simultaneous exchange can occur in three separate ways. The first type of simultaneous exchange is one where you swap deeds with the owner of the other investment property. The second type is a three-party exchange where the transaction between you and the owner of the other investment property is facilitated by a third party called a Qualified Intermediary. Qualified Intermediaries will structure the entire transaction and have training and experience in handling such transactions. Without the help of a Qualified Intermediary, you run the risk of nullifying the 1031 exchange and incurring a large tax burden.
2. Delayed Exchange
A delayed exchange is easily the most common 1031 exchange that you can make. When you conduct a delayed exchange, you will be able to relinquish or sell your investment property before you purchase another investment property. This allows you to use the funds from one sale to acquire another property. This type of exchange can’t occur until you’ve marketed your property, secured a buyer, and have executed the sale and final purchase agreement. A Qualified Intermediary will then need to be engaged to retain the proceeds of the sale until a like-kind property is acquired by the seller.
You will have 45 days to identify a new property and 180 days to close. During this period, the profits from the sale of your previous investment property will be held in a binding trust. Again, while the sale of your new property must be completed in 180 days, you will only have 45 days to find the investment property that you wish to buy. This time-frame gives you some leeway when compared to a simultaneous exchange.
3. Reverse Exchange
A reverse exchange is unique in that you find and purchase an investment property before selling your current investment property. Your current property will then be traded away. By purchasing a new property beforehand, you can wait to sell your current property until the market value of the property increases.
The main issue with this type of exchange is that the transaction typically occurs with 100 percent cash. It’s also important to understand that the majority of banks don’t provide reverse exchange loans. Keep in mind that the purchase of another property with this exchange means that you will have 45 days to determine which one of your current investment properties are going to be relinquished. You will then have another 135 days to complete the sale.
4. Construction or Improvement Exchange
A construction or improvement exchange is a type of exchange that allows you to make improvements to the property before the actual exchange takes place. The property will be placed with a qualified intermediary for 180 days, during which you can use the exchange equity to make the necessary improvements. However, there are three separate requirements that you must meet if you want all gains to be free from taxes.
First, all exchange equity will need to be spent as a down payment or by making improvements to the property within 180 days. The taxpayer will need to receive the same property that was identified on the 45th day, which means that it can’t change significantly. Once the property is given back to the taxpayer, it will need to be at an equal or greater value. These improvements need to be made within 180 days.
Basic 1031 Exchange Definitions
1. What is Like-Kind Property?
The property that you obtain must be a “like-kind property” in order for the transaction to be considered a 1031 exchange. However, this is a broad term, which means that the property you obtain doesn’t need to be exactly the same as the one that you relinquished. Almost any type of real estate can qualify for this exchange. For instance, you could exchange a duplex for an apartment building. Both properties will need to be in the U.S.
2. What qualifies as Investment Property?
The property must be a business or investment property, which means that it can’t be personal property. Your home won’t qualify for a 1031 exchange. However, a single-family rental property that you own could be exchanged for commercial rental property.
3. How do you determine Equal or Greater Value in an exchange?
The equity and market value of the investment property that you purchase will need to be equal to or greater than what you sold your current property for. If your property has a $300,000 mortgage on a $1 million home, the property that you want to purchase must be worth at least $1 million and you must have the same ratio (or higher) debt on the property.
4. What is “Boot”?
The term “boot” refers to non-like-kind property received in an exchange. Typically boot is in the form of cash, mortgage debt or personal property received in an exchange. If you want your exchange to be wholly tax-free, you can’t receive boot on the sale of the property. Any boot that you do receive will be taxed.
5. What does the same Title Holder / Tax Payer mean?
The name and tax return that appears on the property title for the property that you sell will need to be the same as the name and tax return that you provide when purchasing a new property. An exception is allowed if you’re the sole member of a limited-liability company wherein the property is passed from your company to you.
6. The 45-Day Identification Window
No matter which type of 1031 exchange you take part in, you will have 45 days from the close of the sale to find as many as three like-kind properties. If you identify two or three properties, their total value must equal or surpass the value of the property that’s being sold.
7. The 180-Day Purchase Window
Once you sell your current property, you will have 180 days to purchase a replacement investment property and complete the 1031 exchange.
Getting Started With a Section 1031 Transaction
If you feel like a 1031 exchange is right for you, it’s essential that you know what you’re doing and follow all of the rules. The first step is always to contact a Qualified Intermediary to help handle your exchange. Whether you’re conducting a simultaneous exchange or a delayed exchange, the investment property that you choose to buy must be similar to the property that you’re relinquishing. It’s also important that you don’t attempt to use any personal property in this exchange. Keep in mind that you will have 45 days to find a property and 180 days to complete the exchange. Any delay on these time limits could cause you to pay capital gains taxes.
As an investor, these exchanges can be useful in a variety of ways. If you want to diversify your assets with a different property or would like to purchase a property that has better-estimated returns, a 1031 exchange is a great tool. It could also be helpful if you currently manage the investment property that you own but would rather purchase one that’s already managed. While you should now understand how to get started with a section 1031 transaction, this is an incredibly complicated process that comes with many obstacles that need to be navigated. Please contact AB Capital for our list of trusted Qualified Intermediaries.
*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.