The best way to defer taxes on the sale of an investment property is through a 1031 Exchange.
What is a 1031 Exchange?
A 1031 exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains or losses or capital gains tax that you otherwise would have to pay at the time of sale. This method is popular with investors looking to upgrade properties without being charged taxes for the proceeds.
The 1031 allows your investment to continue to grow tax-deferred. There is no limit on how frequently you can do a 1031 exchange. You can roll over the gain from one piece of investment real estate to another and another and another. Although you may have a profit on each swap, you avoid paying tax until you sell for cash many years later.
Step 1: Identify the properties you want to buy and sell
The initial step is to determine the property you want to sell and the property to exchange. The property you’re selling and the property you’re buying must be “like-kind,” which means they must be similar but not necessarily the same quality or grade.
Relinquished/Sold Property
The relinquished property is being exchanged for another in a 1031 exchange. It’s also known as Phase 1 or Downleg.
Replacement Property
A replacement property refers to the like-kind parcel being bought with the proceeds from the relinquished property.
Step 2: Choose a qualified intermediary
Then, you must work with a qualified intermediary, also known as an exchange facilitator, to handle a 1031 exchange transaction. The qualified intermediary holds your funds in escrow for you until the exchange is complete.
You will need to carefully choose an experienced intermediary so that you don’t lose money, miss key deadlines or end up paying taxes now instead of later.
Step 3: Tell the IRS about your transaction
Lastly, you’ll need to tell the IRS about your transaction through IRS Form 8824 with your tax return. On that form, you’ll describe the properties, provide a timeline, explain who was involved in the process and list the money involved. Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
1031 Exchange Timelines and Rules
There are two key timing rules that you must observe in a delayed exchange:
45-Day Rule
Once the sale of your property occurs, the intermediary will receive the cash. You can’t receive the cash or it will spoil the 1031 treatment. Also, within 45 days of the sale of your property, you must designate the replacement property in writing to the intermediary, specifying the property that you want to acquire.
The IRS says you can designate three properties as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
180-Day Rule
The second timing rule in a delayed exchange relates to closing. You must close on the new property within 180 days of the sale of the old property.
What is a Qualified Intermediary?
A qualified intermediary is a person or company that sells your property on your behalf, buys the replacement asset, and then transfers the deed to you.
What are the responsibilities of the qualified intermediary?
- Coordinate with you, the seller, on the structure of the 1031 exchange.
- Prepare the relinquished asset documentation and the replacement property documentation.
- Give instructions and the appropriate documents to the escrow or title company about the exchange.
- Create an arm’s length transaction in the agreement between the seller or exchanger and the qualified intermediary.
- Transfer to the qualified intermediary, who works to convey the asset to the buyer.
- Handle money from the relinquished property sale and deposits these funds into a separate and insured account.
- Hold the funds from the sale of the relinquished property during a 45-day identification period.
- Hold written information about potential replacement properties.
- Transfer funds once the replacement property has been selected and disburses them to the title or escrow company for the purchase of the replacement property.
- Convey the title to the seller or exchanger by deed.
- Keep complete records for the seller.
- Give a 1099 form to the seller or exchanger and the IRS if needed, for interest.
Reverse Exchange
It’s also possible to buy the replacement property before selling the old one and still qualify for a 1031 exchange. In this case, the same 45- and 180-day time windows apply.
To qualify, you must transfer the new property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the transaction within 180 days after the replacement property was bought.
1031 Exchange Tax Implications: Cash and Debt
You may have cash left over after the intermediary acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as boot—will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain.
One of the main ways that people get into trouble with these transactions is failing to consider loans. You must consider mortgage loans or other debt on the property that you relinquish, as well as any debt on the replacement property. If you don’t receive cash back but your liability goes down, then that also will be treated as income to you, just like cash.
Suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property that you receive in exchange is only $900,000. In that case, you have a $100,000 gain that is also classified as the boot and will be taxed.
1031s for Vacation Homes
You might have heard of taxpayers who used the 1031 provision to swap one vacation home for another, or even for a house where they want to retire, and Section 1031 delayed any recognition of gain. Later, they moved into the new property, made it their principal residence, and eventually planned to use the $500,000 capital gain exclusion. This enables you to sell your principal residence and, combined with your spouse, shield $500,000 in capital gain, as long as you’ve lived there for two years out of the past five.
In 2004, Congress tightened that loophole. However, taxpayers can still turn vacation homes into rental properties and do 1031 exchanges. For example, you stop using your beach house, rent it out for six months or a year, and then exchange it for another property. If you get a tenant and record your tenant transaction properly, then you’ve probably converted the house to an investment property, which should make your 1031 exchange legal.
As per the IRS, offering the vacation property for rent without having tenants would disqualify the property for a 1031 exchange.
