What Real Estate Investors Need to Know About the 1031 Exchange Rule
May 8, 2023
Success as a real estate investor isn’t just about buying the best possible properties.
Sure, that’s important. Veteran real estate investors utilize a long list of requirements before deciding to purchase a property.
However, the other secret to their success is that they understand relevant real estate laws and how to best take advantage of them to increase the value of their portfolios.
The 1031 exchange rule is a perfect example.
What Is the 1031 Exchange Rule?
Section 1031 of the U.S. Internal Revenue Code says that real estate investors don’t have to pay capital gains taxes when they sell investment properties provided they take the proceeds from those sales and reinvest them into similar properties of equal or greater value.
In order to take advantage of the “1031 exchange rule”, investors have to use the proceeds to buy their new properties within a certain time range. An investor can purchase more than one property with the proceeds, as well, so long as they’re of similar value.
How Depreciation Affects the 1031 Exchange
If you’re a real estate investor, a 1031 exchange probably seems like a no-brainer.
Who wouldn’t want to avoid paying extra taxes?
With a 1031 exchange, you’re essentially being rewarded for growing your portfolio.
However, the real value of this rule is that it ensures you avoid the dreaded cost of recapturing depreciation once you sell a property.
As a real estate investor, you’re allowed to write off the cost of depreciation on your property every single year.
Then, when you sell the property, capital gains taxes are determined by looking at the house’s net-adjusted value. The equation looks like this:
How Much You Originally Paid for the Property + The Cost of Capital Improvements – Depreciation
Now, if you sell a home and it earns you more than the cost of depreciation, you may be forced to “recapture” that cost. In other words, the taxable income from the sale will include the total amount for depreciation.
So, if recapturing depreciation threatens to increase your taxable income, you can simply use the 1031 exchange rule to avoid the problem altogether.
How to Pick Your Replacement Property
Understanding the massive advantage of utilizing the 1031 exchange rule is one thing.
However, if you actually want to leverage it, you need to understand the four different types of exchanges that are possible.
1. Simultaneous Exchanges
As the name suggests, simultaneous exchanges are when the property being sold and the one replacing it in the portfolio close on the same day.
That last part is important.
If the exchange doesn’t happen literally on the same day, the exchange could be voided, and you’d be saddled with the full weight of the taxes owed. Even something as seemingly insignificant as a short delay in wiring money to an escrow company is sufficient to cancel the 1031 rule’s effects.
There are three different types of simultaneous exchanges:
- Two parties can essentially exchange deeds
- A three-party exchange, whereby Party C buys Party B’s property and then exchanges it for Party A’s property, ensuring they don’t have to pay capital gains taxes on the sale.
- A simultaneous exchange whereby a Qualified Intermediary (QI) oversees the entire exchange (e.g. providing written instructions to the closing officer, preparing exchange agreements, etc.)
2. Delayed Exchanges
Far more often, investors opt for delayed exchanges.
By doing so, the investor relinquishes their current property before purchasing another to replace it.
Before acquiring the new home, the investor must market their current property, secure a new buyer, and execute the sale and purchase agreement.
Then, they have to hire an Exchange Intermediary (EI) to both initiate the sale and hold its proceeds in a binding trust while the investor purchases a similar property as a replacement.
With a delayed exchange, the investor is given 180 days to sell their current property and another 45 to find its replacement.
This extended timeframe is one of the main reasons it’s so popular with investors. They can take advantage of an opportunity to sell without having a replacement property in mind right away.
3. Reverse Exchanges
Sometimes referred to as a forward exchange, a reverse exchange is when an investor acquires a replacement home before selling their current property.
Put another way, the investor secures the property they want first and then sells the home they need to relinquish so they can take advantage of the 1031 exchange rule second.
Obviously, this is an attractive prospect for any investor, but the catch is that it requires all cash. Most banks don’t like facilitating loans for reverse exchanges, either.
Similar to delayed exchanges, the investor has 180 days to sell their property. Otherwise, the reverse exchange is void.
Still, there are some very important differences:
- Investors are given 45 days to choose which property they will sell.
- After that time period, investors have 135 days to execute the sale and complete the purchase of another.
4. Construction Exchanges
With a construction exchange, investors can pay for improvements on their new property using equity from the exchange.
Once again, the investor has 180 days to take the tax-deferred proceeds and use them to improve their replacement property. During this time, the new property is entrusted to a QI until the conclusion of the 180-day period.
All of the equity from a construction exchange must go towards improving the replacement home and/or making a down payment on it. Once the new property is deeded back to the investor, it must also be of equal or greater value and it will only be returned after the improvements are 100% complete.
Keep Costs Down on Your 1031 Exchange
Over time, capital gains taxes can greatly reduce the value of your real estate portfolio. That’s why it’s so important to take full advantage of the 1031 exchange rule. It’s one of the smartest ways to increase how much your property is worth while simultaneously avoiding unnecessary taxes.
You can also save even more money when executing exchanges by selling and buying with our low commission real estate agents. Our 1% commission real estate agents will save you $7,500 on average when you sell one of your homes and give your listing the awareness it needs to sell. Likewise, we offer a buyer refund of up to $15,000 whenever you choose one of our real estate agents to facilitate the purchase of a new home.
Contact us today to learn more about how we are changing the way real estate is done.
The 1031 Exchange Rule presents an invaluable opportunity for savvy real estate investors to defer capital gains tax on the sale of an investment property. By adhering to the guidelines set forth by the Internal Revenue Code, investors can strategically navigate the process of exchanging their relinquished property for a like-kind business or investment property, such as vacant land or rental property. This exchange allows investors to defer capital gains taxes while growing their portfolio and maximizing returns on real property investments.
It is essential for real estate investors to understand the role of a qualified intermediary, who will hold exchange funds and facilitate the transfer of both the relinquished property and potential replacement properties. The Internal Revenue Service mandates that the fair market value of the acquired property must be equal to or greater than that of the relinquished property sale, and that specific timelines are met throughout the exchange process. Investors should also be aware that certain assets, such as personal property and partnership interests, are not eligible for 1031 Exchange Rules benefits.
By staying informed about the intricacies of the 1031 Exchange Rule, real estate investors can confidently navigate the process, defer capital gains tax, and optimize their investment strategy. Leveraging the knowledge of a qualified intermediary and adhering to the guidelines set by the Internal Revenue Code will ensure a smooth transaction and provide a valuable advantage in today's competitive real estate market. With the right resources and understanding, the 1031 Exchange Rule can be an essential tool for maximizing returns on investment property while minimizing tax liabilities.