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5 things you need to know about 1031 exchanges

1031 exchange

Most people who purchase real estate have heard the term 1031 exchange, but not a lot of people know all the nuts and bolts. Here are the 5 things you need to know about them.

What is an 1031 exchange?

A 1031 exchange is a very popular way for you to build wealth with real estate. In involves selling one piece of real estate for another and deferring capital gains tax until sometime in the future. It is very popular with large real estate investment groups and real estate moguls. The good news is that it also works for small real estate investors like you!

How does a 1031 exchange work?

A 1031 exchange is when you exchange investment real estate property to defer paying capital gains taxes. In most instances, you perform a 1031 exchange with two properties, the Original Investment Property and a New Investment Property.

For a 1031 exchange to work, you will need to sell your original investment property and invest the proceeds into a new investment property. The two properties have to be “Like-Kind” in order for you to not pay capital gains tax. Like-kind to the IRS means exchanging investment property to investment property. You cannot do a 1031 exchange from an investment property to a new personal home.

One of the most important rules to a 1031 exchange is that you may never touch the money yourself. That means when you sell the original investment property, the proceeds from the sale cannot go into your personal bank account. They must go to a special company’s bank account. That special company that holds the money for you, is called a Qualified Intermediary.

What is a Qualified Intermediary?

A Qualified Intermediary (also known as an accommodator or facilitator) is an independent agent that works on your behalf to help with the 1031 exchange. They hold the proceed from the sale of the original property in escrow, and when you are ready to purchase the new property transfer the funds. Per the IRS there is a certain list of people that cannot be your Qualified Intermediary, those people are:

  • Yourself
  • Your relative
  • An employee
  • An attorney
  • Your CPA
  • An investment Broker
  • Your real estate agent

To avoid tax, the government wants you in a worse off position

In order for you to pay no capital gains taxes, the government wants you in a worse off position after you purchase the new investment property. This means that when you buy the new investment property, it has to be more expensive. You will have to either:

  • Put up additional money, or
  • Take out a bigger loan

This usually throws off a lot people, since many people would like to take some money off the table without owing any tax. Remember, Uncle Sam doesn’t believe in freebies! Any money that you take off the table and is deposited in your personal bank account taxable.

Time limits – 45 day rule and 180 day rule

There are also a couple important time limits that the IRS has given on how fast you have to do a 1031 exchange.

45 day rule – After you sell your original investment property, you will have only 45 days to identify your New Investment Property. If you don’t identify it within 45 days, the exchange is invalid. That is why it is a good idea to identify multiple new investment properties and send the list to your Qualified Intermediary. That way if the purchase of your new investment property falls through, you will have a backup property that you’ve already identified within the 45 day period.

180 day rule – You have 180 days (approximately 6 months) to close on the sale of the New Investment Property. If the closing date of your new property falls outside of the 180 days, you will lose the 1031 tax benefit and have to pay tax. So make sure that your realtors, qualified intermediary, and title company pay very close attention to the closing date of the new investment property, so you don’t exceed the 180 day rule.

Can I do a 1031 exchange with my home?

1031 exchanges only work with real estate investment property. Even though many people think of their primary residence as both a home and an investment, that’s not the way the IRS sees it. However, there is some good news, Congress came up with a special home tax break for your primary residence.

If you’ve lived in your primary residence for 2 out of the the last 5 years, the first $250,000 of capital gain is tax free (if you’re married, $500,000 is tax free).

Can I get the special home tax break this with my 2nd home or vacation property? Unfortunately, the answer is no. You can only get the special home tax break on your primary residence.