The opportunity to sell (exchange) rental real estate property without creating an immediate tax liability is one of many great things about real estate investing. By doing a 1031 Exchange, a property owner is able to defer any tax on the profit of the sale by rolling those profits into the purchase of another rental property. The concept has been around since the early 1900’s and technically is not an elimination of tax but rather a deferment of tax so long as the proceeds of the sale go towards the purchase of a “like-kind” property (i.e. another rental property). So not only do you have a larger sum to invest in the next property, but there might not ever be a requirement to pay tax on your gain if your property is inherited by heirs that receive a step-up in basis on the property. As you can imagine, this creates a significant opportunity for wealth generation and wealth transfer.
In case you are entertaining the idea of doing a 1031 Exchange, there are a couple of points to keep in mind as you plan your exchange:
- The rental property being exchanged into has to be considered “like-kind” with the property being sold. The definition of like-kind in this situation means any real property held for rental or investment. It does NOT mean you have to exchange a single family house for another single family house. For example, you could sell a duplex and buy a 5 unit building or you could sell 4 single family homes and buy a self-storage facility. The point is the purpose of each beginning and ending property is for use as a rental investment.
- The value of the property being exchanged into must be equal or greater in value to the relinquished property. In other words, you must trade up in value with the purchase price of the new property being equal or greater to the sale of the previous property.
- The IRS requires you to utilize the services of a 3rd party custodian, a 1031 Exchange Intermediary, to handle the transaction and funds. You cannot take possession of the proceeds of the sale of your relinquished property without negating the exchange. Another point to remember is that you also must involve the exchange intermediary BEFORE you close on the sale of the relinquished property. If you wait until after closing they will not be able to help you and you will not be able to do a 1031 exchange. Identify a company you would like to use early in the sale process so they can be listed in your sale documents as well as advise you along the way.
- There are two time frames that are important to remember when doing an exchange. You have 45 days from closing on the sale of the relinquished property to identify and submit to your exchange intermediary which property(s) you intend to acquire. Then you must close on the purchase of the new property(s) within 180 days of closing on the sale of the old property. There is no wiggle room in these time frames, so time is definitely of the essence in working to get your exchange closed successfully.
- You must purchase and take title to your new property in the same name as the relinquished property. The main idea behind this is that the properties have to stay under the same social security number or tax ID number. So, if you are selling a property in your individual name you will also have to take title in your individual name with the new property. Likewise, if you are selling a property that is in an LLC called “123 Main Street, LLC” you will also be taking title to the new property with that same LLC.
- You must reinvest 100% of the net proceeds of the sale of the relinquished property, otherwise you will create taxable “boot”. You are allowed to take money out, but just make sure you are aware that any money from the sale that is not reinvested will be taxable, likely at your capital gains rate if property has been held long-term.
- There are variations of the 1031 Exchange that allow situations such as the purchase of a new property before the sale of the old property (Reverse 1031 Exchange) or the use of funds to purchase and renovate a new property (Improvement 1031 Exchange), but the most common type of exchange is the Delayed 1031 Exchange where you sell a property and then roll those funds into the purchase of the next property(s).
I would love to hear comments from any of you about your experience doing a 1031 Exchange. Although strict guidelines must be adhered to in order to complete an exchange successfully, it is easy to see how utilizing this benefit of the tax code can give you greater momentum in your real estate investing goals.