The Nuances of 1031 Exchanges
In a previous blog post, we covered the rules and benefits of 1031 Exchanges, which, for real estate investors, is an excellent resource to understanding the basics of this tax-deferral tool.
To go more in depth on the nuances of 1031 Exchanges, below you will learn more about what a 1031 exchange is and what it is not; the identification period and 3-property rule; and a few ancillary topics.
What a 1031 Exchange Is & What It Is Not
If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This procedure gives you the ability to take an investment in real estate, relinquish it, and get an investment back.
It’s important to note that it must be trader business or investment real estate on the front end, and trader business or investment real estate on the back end. 1031 used to be much broader in scope, but The Tax Cuts and Jobs Act shrunk it to basically just a real estate play.
Real estate has carved out a niche in the ability to trade from one property to another; and the good news is, 1031 is not a target of new legislation. In fact, it is here to stay and should continue to be vibrant for a long time.
Now, let’s discuss what a 1031 is not…
- You can not trade for inventory assets or assets that are for sale
ie. Residential lots
- You can not trade a fee-simple real estate ownership a partnership interest
- You can not trade personal use assets for trader business use assets or vice versa
Example: When trading a real estate investment (raw land) you can trade this for a hotel play, apartments, duplexes, or commercial property rental – as long as it’s trader business or investment real estate for trader business or investment real estate.
Identification Period and 3-Property Rule
The first thing to remember is the date of relinquishment of your property (which is also the date you get rid of it and the closing statement occurs). That’s the date that gets everything rolling. It’s technically driven, and there’s a lot of nuances to follow, but you’re basically selling one and replacing it with another.
You have 45 days from the initial day of relinquishment to identify what you want to get in return, which is what you call the identification period. Then, from the initial relinquishment date, you have 180 days to acquire the replacement property.
During the identification period, there are two common rules you’ll need to understand:
- The Three Property Rule
a. Permits the taxpayer to identify up to three replacement properties of any value (ie. $100,000 that you’re giving up – you can identify a $300,000, $4M, and $100,000 piece. As long as it’s only 3 replacements to complete the exchange, that’s fine.)
b. The Three Property Rule lets you explore options to what you can acquire to complete the exchange.
- The 200% Rule
Once you go over 3 properties or want more options, you’ll face the 200% rule, where you look at the value of what you gave up.
Most taxpayers choose to follow the Three Property Rule due to its simplicity. The 200% Rule and 95% Rule (another option to explore), require careful planning.
Realized Gain vs Recognized Gain
In short, the realized gain is the actual gain on the transaction, as if you were to sell it, which is calculated by taking the fair market value with sales price, less your basis, less your closing costs that apply to the sale. The realized gain is “recognized,” or taxed, only to the extent of the net boot received by the taxpayer.
For a fully deferred exchange, say you gave up a property that had a $100,000 worth of value and no debt – the two rules you have to watch are: 1) trade equal or up in value and 2) equal and up in equity.
With the example above, you can see:
Value = $100,000 and Equity = $100,000
Now, if you go and replace it with a $200,000 piece of property, you could finance the extra $100,000 to get there. Therefore, you’ve traded up in value and now your equity is equal.
Lastly, the concept of boot comes into play with the cash you may receive. If you receive cash or other property that isn’t qualifying, that’s considered boot, and is taxable.
The basic transaction costs, or “exchange expenses” are the costs to actually sell or replace the real estate.
These expenses could be included on a closing statement and include:
- Broker’s commissions
- Legal and accounting fees in connection with the sale of the relinquished property or acquisition of the replacement properties
- Qualified intermediary and exchange accommodation titleholder (for reverse Section 1031 exchanges) fees
- Property appraisal fees
- Recording fees
- Title insurance
- Sales and transfer taxes
These are the fees that would be baked into what the realized gain actually is. It’s cost that would reduce the gain.
If you are planning to sell an investment property you own or plan to accumulate properties throughout your lifetime, the benefits of utilizing a 1031 exchange make it worth considering. And if you determine that a 1031 exchange is right for you, then it is important to work with qualified professionals to ensure all the rules are being followed.
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