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1031 Exchange Explained: The Basics for Real Estate Investors

Three words that can make or break an investor – capital gains taxes. The taxes from selling your investment property range from 15 to 30 percent, when state and federal taxes are combined. Ouch, there goes your profit margins or money for future investments. So how can you, as an investor, avoid them? The 1031 Exchange.

The 1031 Exchange is a powerful tool, making it a favorite among savvy and successful investment professionals. Let’s dive into the basics of the 1031 Exchange.

What is a 1031 Exchange?

A 1031 exchange gets its name from the Internal Revenue Code, Section 1031, which allows you to avoid paying capital gains taxes on an investment property upon its sale – as long as the profits are reinvested in like-kind properties. Like-kind refers to the nature or character of the investment rather than the form; therefore, any investment property can be exchanged for another type of investment property. In theory, an investor could defer capital gains on investment properties until death, potentially avoiding them altogether.

What real estate investment-properties qualify for a 1031 Exchange?

There are two parts of the exchange. The first half is the property you currently hold. This property must be held for business or investment use to qualify – meaning no personal residences. Property held “primarily for sale” is also excluded, such as a fixer-upper, vacant land being developed into

a house, or vacation or second homes. That said, you can still utilize a 1031 Exchange if you rehab a property and rent it out before selling. The IRS perceives this as a long-term investment; therefore, eligible for capital gains tax deferment.

The second half of the exchange is the property you intend to acquire. This is the property that must be like-kind to the property you currently hold, meaning it must also be an investment property. According to the IRS, like-kind property is defined as:

“Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.  For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States.  Also, improvements that are conveyed without land are not of like kind to land.”

Is a Qualified Intermediary needed?

You will likely need a Qualified Intermediary (QI) to serve as a third-party to accommodate the sale, and hold subsequent payout from the property you currently hold. The QI sells your property and buys the replacement asset on your behalf before transferring the deed to you. They ensure the transaction is completed successfully and within the IRS guidelines, so you’ll want to choose a reputable one. A great way of finding a QI is to ask your local escrow officer for a recommendation.

Are there deadlines for a 1031 Exchange?

To qualify for the 1031 exchange, the like-kind exchange does not have to be an immediate swap of properties, but you do have to meet two time limits or your gains will be taxed.

The clock starts once the sale of your currently held property takes place. From that point, you have 45 calendar days to identify your replacement property. The replacement property must be clearly described in writing, signed, and delivered to someone involved in the exchange. Notifying your attorney, real estate agent, accountant or someone acting as your agent does not qualify.

The second limitation is that you have 180 days from the time you close on the sale of your current property to close on your selected replacement property. Both time limits are triggered on the same day, and there are no extensions or exceptions. The only event that would change this time limit would be the due date of your tax return. If your return is due before the 180-day window, then that date would become your new time limit.

Is it worth it?

Yes. If you intend to continue to invest your money in like-kind real estate, you should never have to pay capital gains taxes again. As mentioned before, it’s possible you can defer your taxes indefinitely. If you have heirs and they inherit a property that was received through a 1031 exchange, all deferred taxes are erased because they would be receiving it at the market rate value. This makes a 1031 Exchange a powerful tool for building a portfolio using pre-tax dollars.

Broadmark Realty Capital Inc. is a hard money lender specializing in construction and development financing. We work with builders and developers who require quick closings, outside-the-box thinking, and the utmost professional service. Our ability to close quickly on loans can help give you confidence that you will qualify for the 1031 Exchange.

Please note – this blog was written as useful information and should not be treated as legal advice. It’s always best to seek guidance from the experts.