Provided By Tim Beldner, Partner and Senior Advisor at Larson Financial Group
Real estate investments can be a lucrative way of diversifying your existing income portfolio while also securing an additional income stream. When the time comes to sell an investment property, your profits could be severely diminished by the capital gains tax which can run as high as 15% to 30% when state and federal taxes are combined. However, if you intend to reinvest the proceeds of the sale in more investment property, there’s a way to minimize the amount of capital gains or potentially avoid the tax altogether.
Section 1031 of the U.S. Internal Revenue Service Code allows investors to legally defer the capital gains tax on the sale of a property for business or investment purposes if the money is being used to purchase another similar property. This is referred to as a 1031 exchange, and it’s a powerful wealth-building tool leveraged by many successful real estate investors.
What is a 1031 Exchange?
The idea behind a 1031 exchange is that when an individual or business sells a property to buy another, no economic gain has been achieved. There has simply been a transfer from one property to another. Most 1031 exchanges are of real estate, but some exchanges of personal property may also qualify.
In order to be eligible for a 1031 exchange, the property being sold and the property being acquired must be “like-kind.” This is a fairly broad term meaning that the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” For example, the exchanger could sell a piece of bare land and buy an apartment building, or vice versa, since these meet the “like-kind” standard.1
A 1031 exchange is only applicable for investment or business property, not personal property. In other words, you can’t swap your primary residence for another home or investment property. It’s also important to note that the original and replacement property must be within the U.S. to qualify under section 1031.2
Guidelines for a 1031 Exchange
There are a couple of strict timing deadlines that must be observed when conducting a 1031 exchange. The property owner has 45 days, post-closing of the first property, to identify up to three potential replacement properties in writing. This time period includes weekends and holidays and is non-negotiable, so if you exceed the time limit the entire exchange can be disqualified.3
Once identified, the exchanger has 180 days from the date the property was sold to close on one of the properties from their list. However, if the due date on the investor’s tax return (with any extensions) for the tax year in which the relinquished property was sold is earlier than the 180-day period, then the exchange must be completed by the earlier date. There are no extensions or exceptions to this rule, so it is recommended to schedule the closing prior to the deadline if possible.4
The tax return, and name appearing on the title being sold, must also be the same as the tax return and title holder that buys the new property. However, there is an exception to this rule if you are the sole member of a single member limited liability company. Under this scenario, your LLC would sell the original property owned by the LLC, but you could purchase the new property in your individual name and still be in compliance with the 1031 code.2
Generally, the goal is to acquire a property of equal or greater value to the one you’ve just sold in order to keep the exchange tax-free. However, if you want to make some cash off the sale and don’t mind paying the taxes to do so, you can acquire a new property of lesser value and keep the remainder of the proceeds from the sale of the original property. This remaining amount is known as “boot” and will be subject to taxation at the capital gains rate. Keep in mind that any acquisition costs, such as inspection and broker fees, can be applied toward the total cost of the new property.4
The Bottom Line
To facilitate a 1031 transaction, the exchanger must use a qualified intermediary which is an independent 3rd party who holds the sale proceeds and purchases the replacement property on your behalf. If you were to personally receive the cash from the transaction, it would spoil the 1031 treatment and trigger a taxable event on the money received. It is extremely important to associate only with qualified intermediaries that are bonded, insured and reputable.3
A 1031 exchange is a complex transaction and not a recommended maneuver for the “do it yourself” investor. If you’re just getting started in real estate investing, make sure you familiarize yourself with real estate market cycles and growth opportunities before you even think about attempting a 1031 exchange. Before executing a 1031 exchange, it’s recommended that you seek help from a tax professional familiar with real estate transactions as even a small mistake can jeopardize the deferment of your capital gains tax.
- First American Exchange Company “1031 Exchange”. https://www.firstexchange.com/1031-glossary
- Benjamin Smith “How to Do a 1031 Exchange: Important Rules & Definitions to Know for 2018” (October 2017). https://www.realwealthnetwork.com/learn/1031-exchange/how-to-do-a-1031-exchange-rules-definitions/
- Elizabeth Weintraub “What is a 1031 Tax-Deferred Exchange?” (August 2016). https://www.thebalance.com/what-is-a-1031-exchange-1798141
- Elizabeth Weintraub “How to Do 1031 Exchanges to Defer Taxes” (May 2017). https://www.thebalance.com/how-to-do-1031-exchanges-1798717
This article was written by Larson Financial Group, LLC and provided courtesy of Tim Beldner, Partner and Senior Advisor. Advisory Services offered through Larson Financial Group, LLC, a Registered Investment Advisor. Securities offered through Larson Financial Securities, LLC, Member FINRA/SIPC.
Larson Financial Group, Larson Financial Securities, and their representatives do not provide legal or tax advice. Please consult the appropriate professional regarding your legal or tax planning needs.