What is the 1031 Exchange rule and how you can use that to avoid taxes – everything you need to know

Are you a landlord who hates having to pay the Capital Gains tax on every property you sell? Or are you someone who has heard about the 1031 Exchange but don’t know where to start? Well, you are in the right place! This article has everything there is to know about Capital Gains tax, 1031 Exchange, what types of Exchanges it applies to, and how to use it to your advantage. Paying taxes when you sell a property can quickly eat into your profits. If you plan to upgrade to a different property or similar investments, take advantage of Capital gains.

Capital Gains tax

Let’s dive right into this. The first thing you need to be clear about is what Capital Gains Tax is. Capital Gains Tax is the tax you pay on the profit you receive from selling some property. It is assessed by deducting the sale price of the property from its original price. Thus, you pay the tax on how much profit you earn. The tax is only applicable once the asset has been sold. Capital Gains Tax is paid to the Internal Revenue Service (IRS), which is a government body responsible for tax collection.

What is the 1031 Exchange?

The 1031 Exchange is a procedure that allows landlords and other property sellers to sell their property and buy a property like the one they just sold, all the while deferring Capital Gains Tax. Simply put, you are transferring your money from one property to another property, or you are exchanging properties. The rules that govern the 1031 Exchange procedure are set out in Section 1031 of the U.S Internal Revenue Code. Yes, that is where it gets its name from!

Read about the pros and cons of buying properties with cash vs mortgage.

How it works

1031 Exchange applies to people who are buying another property, not to the ones who are taking the cash out. You cannot simply sell your property and keep the profit from it, in the name of the 1031 Exchange, because under Section 1031, all proceeds from a sale of an asset are taxable. Think of it like this – you are exchanging your property for another one, and avoiding taxes throughout this, at least for the time being. Many investors use this procedure to trade properties without having an obligation to pay taxes all of a sudden. However, this is only applicable successfully when the value of the property you are exchanging (buying) with must be equal or more than the value of your old property (selling). This means if an investor is selling a property in California for $1 million, he or she will need to buy a property worth $1 million or more.

Cash flow or appreciation – pros and cons of both approaches?

Read our tips on investing in Class C properties to improve cash flow

The way it works is, to avoid taxes on the profit you just made, you need to invest that profit into another asset. This is where the role of qualified intermediaries comes in. Once you sell your property, the profits you earned from the sale must be transferred to a qualified intermediary. The qualified intermediary facilitates the 1031 exchange by holding on to the profit made by the sale of your property until you are ready to complete the transaction and purchase a new property. The money is then transferred to the seller of the second property, by the qualified intermediary. The qualified intermediary can have no relationship with the two parties involved in the buying and selling of the property. It must be a neutral party. It can be a person or a company, however we advise you to hire a professional to help facilitate the 1031 Exchange for you. This is simply because of the complex nature of the procedure.

8 Key skills to succeed in real estate investing

Using the 1031 Exchange procedure means you can avoid taxes until you sell your property and take the cash. If you simply exchange your properties for those of the same or higher values, you may never have to pay the Capital Gains tax!

The types of real estate exchanges

There are four ways that real estate is exchanged. The 1031 Exchange procedure can be used on each of these.

1. Simultaneous exchange: This type of exchange is when an investor sells his property and buys a new one on the same day, thus gaining its name, as it usually happens simultaneously.
2. Delayed exchange: this is the most common type of exchange. This is when the investor sells his property, but waits to acquire ownership of the second property.
3. Reverse exchange: in this type of exchange, you acquire ownership of the property you want to buy first, and then sell off your old property. Investors have a maximum of 45 days to relinquish one of their properties. It is also called the forward exchange.
4. Improvement exchange: this is when the investor uses the tax-deferred dollars (saved due to using the 1031 Exchange procedure) to make changes to or improve the conditions of the property they are set to buy. They do this while the property is owned by a qualified intermediary. This can go on for a maximum of 180 days.

What are property class A, B, and C and which one is right for you?

The rules of 1031 Exchange

Using the 1031 Exchange procedure to save up precious money that would have gone to tax otherwise can be a very useful and intelligent thing to do when you are an investor or a landlord looking to sell your property. However, to go through with this successfully, you need to follow the specific rules that the 1031 Exchange is governed by. There are 7 rules in total, and they are explained below.

1. Same place: If you are selling a property located inside the United States, you cannot buy property outside the U.S and expect the 1031 Exchange rule to work for you. The replacement property you purchase next must be inside the U.S if you want to avoid paying taxes to the IRS. However, you can buy property located outside of the U.S if the original property you sold is also located in a foreign country. Note that the two foreign properties you are exchanging do not need to be located in the same country. They just need to be outside of the U.S.
2. ‘Like-kind’ properties: The two properties being exchanged must be ‘like-kind’. This means they must be similar in value and nature. They can, however, differ in quality. This definition may seem vague to you, so let us put forth an example. You cannot exchange fishing equipment for a shopping plaza space, even if the two are of the same value. This is because they are not of the same nature. They are two different types of assets. However, you can exchange one property for many properties, or exchange a house for a commercial building or vice versa as long as they are equal or greater than the proceeds from the sale of the first property.

Real estate or stocks – which one is better?

3. Not for personal use: A 1031 Exchange cannot be used to exchange personal property. This means that if you were to move from Connecticut to Virginia, you would not be able to exchange your home in Connecticut, for the one in Virginia. Your primary residence also cannot be exchanged with a vacation home. The 1031 Exchange can only be used for investment or business purposes.
4. Property value: If you want to avoid paying any taxes, exchange your property with one that is of equal or greater value. For example, if your property is worth $4,000,000, the property you plan on purchasing much also be worth $4,000,000, or more. If it is worth less, it may still qualify for a partial 1031 exchange, but this will not be completely tax- free. You will have to pay Capital Gains tax on the difference, or rather, on the profit you earn from selling your property and buying one that is worth less. This difference is called Boot. An example of this is that if your property is worth $4,000,000, and you exchange it with one worth $3,000.000, $1,000,000 will be considered the ‘Boot’. This is what you will have to pay Capital Gains tax on.
5. Taxpayer particulars: The name on the title of the property being sold, along with the tax return must match the name on those of the property being bought. Keep this in mind if you are part of a company that buys and sells real estate. However, there is an exception to this rule. This exception goes for single-member limited liability companies. These companies only have one member each, so the sole member may buy and sell property on their own name.
6. 45 days: Once you sell your property, you have up to 45 days to identify 3 potential properties you want to purchase, and apply the 1031 Exchange rule to. However, due to today’s real estate prices based on the constantly evolving market and ever-changing interest rates, this can be difficult. But, do not fret, because there’s a solution to this! There is an exception to the 45-day rule, called the 200% rule. Applying this exception, you are allowed to list 4 or more properties you may be interested to buy, as long as the value of those properties altogether does not go beyond 200% of the value of the property you sold.
7. 180 days: The last rule is that you must complete the purchase of your new property within 180 days of selling your old one, or you cannot apply the 1031 Exchange rule. Note that the 45 days rule runs concurrently with this one. So, if you identify what property you will be buying exactly 45 days after selling your original one, you have 135 days left to buy it.

Consider these 3 things before investing in real estate

If you have wondered what a 1031 Exchange is and how it works, this article has all you need to know about it. Once you understand how it works, you will realize it is not that difficult. The 1031 Exchange is a great way to save thousands, even millions of dollars that would have been paid to the IRS in the form of Capital Gains Tax. Check out HomeKasa for more articles on real estate and how the market works!

HomeKasa offers the best property management software to manage your investment properties. You can collect rent, schedule repairs, manage profit and loss, and more from one place. It’s free, get started now.