Like the Indy 500 is to racecar drivers, so too is the 1031 Exchange for real estate investors. It’s all about precision, timing and it happens quickly. But at the same time, you can be a winner if you stay in it for the long haul. If you own real estate held for investment, under Internal Revenue Code (IRC) Section 1031, you are allowed to exchange your existing property (relinquished property) for another property (replacement property) and defer paying taxes on your realized capital gain as long as you reinvest the proceeds into other “like-kind” property held for investment. Imagine for example the race event is your investment horizon and the “pit stop” is your “1031 Exchange.” You can continue your tax deferral with your replacement property or stop for another “pit stop” or 1031 Exchange later during your investment-holding period.
Reasons you might consider a 1031 Exchange would be to relocate/reposition, diversify or even increase your real estate investment portfolio. Here are some examples that might help you determine if a 1031 Exchange is right for you.
Example KEY: 1031 Exchanges that work (✓) and do not work ( 🚫 ):
Relocate/reposition: Three-bedroom rental house in Kaneohe for a three bedroom rental house in
✓Kapolei near rail, UH Westside and Costco
✓Las Vegas, Nevada near the “Strip”
🚫 Tahiti or Fiji
🚫 Paris, France
Diversify: large land parcel in Waianae for
✓A condominium and a townhouse rental unit
✓A commercial office property or retail store
🚫 A partnership interest in a commercial office properties
🚫 A portfolio of mutual funds, stock, bonds, or REIT investments
Increase: duplex rental property for
✓A ten unit apartment building
✓A commercial retail shop or center
🚫 North shore vacation beach house for family members
🚫 Large multi-generational home for family members
With a closer look at these examples, take note that “like-kind” for purposes of IRC Section 1031 is basically domestic “real property” for domestic “real property”. So, for example, you are able to exchange a rental house for: another rental house, condominium, apartment complex, commercial retail or office building, or even vacant land held for investment. While the tax laws provide a very generous definition, it is also noted that “like-kind” for purposes of a 1031 exchange does not include: real property located in a foreign country, held for personal use or held in a separate legal entity (where the property you actually own is an intangible/personal property asset in the form of a partnership or member interest, stock, or other right), stock in trade or real estate held primarily for sale (inventory) or other personal and personal use property.
With a 1031 Exchange, your recognition of capital gains may be 100% tax deferred or, in the case that nonlike-kind property (called “boot”) is received, you are only able to achieve partial tax deferred such that gain is triggered to the extent that you receive money or other value from the disposition of your relinquished property.
Just like the Indy 500 racecar driver, your “pit crew” for your 1031 Exchange is critical to achieve a successful income tax deferral. Each team member of the pit crew is trained for a specific role and each member takes their preparation as seriously as the racecar driver in knowing their sport and their craft. In the case of a 1031 Exchange, your professional “pit crew” of advisors should include:
- Qualified Intermediary (QI)
- Your real estate agent
- Your CPA
- Your attorney
- Escrow & title officers
- Exchange Accommodation Titleholder (EAT)(for a reverse exchange)
The 1031 Exchange provisions mandate that the real estate investor follow specific rules that require both precision and timing with regard to the following requirements:
- Identification Period = 45 day period following close of sale for the relinquished property during which you are required to provide a written list of potential replacement properties to be acquired and
- Exchange Period = 180 day period following close of sale of for the relinquished property during which you are required to complete the acquisition of the replacement property(ies)
These time periods run simultaneously, so it happens quickly and your professional “pit crew” can help keep you on track and on course for a successful transaction.
It is important to emphasize that a sale of property followed by a reinvestment of the proceeds into another property does not qualify for tax deferral under IRC Section 1031. In general, a sale is the receipt of cash or other monies for the transfer of a property, whereas an exchange is the transfer of a property(ies) in return for the receipt of property(ies) (other than cash or other monies) among the parties to the transaction.
In the real world, simultaneous exchanges are just not common because real estate in and of itself is not a fungible asset, but rather each property by its nature (location, age, construction, etc.…) is different and so too are the values for each property. In other words, it is not likely that Investor A could make an even trade of his property for the property of Investor B at such a time that each would want the other’s property and each of their real properties had the same exact value. In most instances, a non-simultaneous (reverse or delayed) exchange is performed requiring a third party to facilitate the exchange using a QI or in the case of a reverse exchange, using both a QI and EAT.
Lastly, when you are finally ready to liquidate your real estate investment, it is important to note that “tax will follow the cash”, meaning when you divest and cash-out of your real estate holding(s), this will now trigger income taxes to be recognized on your prior deferred capital gains as well as any additional appreciation of the property since your last like-kind exchange. However, “at the checker flag” (meaning at your death), the current federal tax laws provide a “step-up” in income tax basis for assets included in your gross estate for federal estate tax purposes. And, “POOF!” your prior deferred capital gains as well as any appreciation of the property since your last like-kind exchange is eliminated. At this point, your estate or heirs can then sell the “stepped-up” real property with no income tax consequences. Thus, you can be a winner if you stay in the race for the long haul.
If you think a 1031 Exchange is right for you, contact your REALTOR® and consult your tax advisor as the federal, state and local income tax laws are complex.