1031 Exchange Basics
Quick question: Have you ever heard of a 1031 exchange? If you haven’t, we don’t blame you. There are many investment vehicles a savvy real estate investor may use to turn a profit. Whichever you choose, you need to know which tax tools you have at your disposal. For investment properties, you’re going to want to learn how to do a 1031 exchange.
This tool can be used to defer taxes on real estate, so learning how to do a 1031 exchange may come in handy if you ever buy a property. Before you head into the world of real estate investing, you need to first understand the 1031 exchange basics. We’ll answer the 1031 exchange FAQ so you can place this tax tool in your investing toolbox.
What is a 1031 Exchange?
In short, it’s a swap. Specifically, it’s a swap of one investment or business asset for another—with no tax. With that in mind, let’s cover the 1031 basics.
For an investor, the need-to-know 1031 basics: This tax tool allows you to defer capital gains by reinvesting them in a “like-kind” property, and can allow a smart investor to postpone paying taxes until your sales actually end up giving you cash in-hand. So, rather than paying taxes upon the sale of your investment property, which can be quite costly, it lets you transfer the value of that property into another one.
1031 Exchange FAQ
Beyond the 1031 exchange basics, the rules are actually quite broad—so there are some common 1031 exchange FAQ. As with any tax laws, it comes down to the fine details. And when it comes to real estate investing, those fine details can translate to tens of thousands of dollars. With that in mind, let’s go over the 1031 exchange FAQ that you may still have.
What counts as “like-kind” property?
Just about anything that is a business or investment property counts as “like-kind” property, so you aren’t limited to swapping a house for another house. Thus, a 1031 exchange can be executed with residential real estate or commercial real estate. Vacant land is like-kind to a house, while an apartment building is like-kind to a townhouse. There are a few rare exceptions, though. For example, raw land in a foreign country is not like-kind to raw land within the United States. It’s best to double check before you get serious about how to do a 1031 exchange.
Do you have to purchase another property right away?
Timing doesn’t always line up, and there may not be another seller on the market at the same time. Fortunately, you have a window of time during which you can perform the 1031 exchange. Typically, you’ll work with a third party intermediary which holds the cash following your sale. Then, the intermediary buys the swapped property for you.
How long do I have to make a 1031 exchange?
If you’re going to learn how to do a 1031 exchange, you’re going to need to know the timing. Once the third party has received the cash, you start two timers simultaneously. You have 45 days to specify (in writing) up to three properties you want to acquire. You don’t have to have settled on one quite yet. As long as you eventually close on one of the three properties you specified in writing, your swap will count as a 1031 exchange. At the same time as your 45-day timer starts, you’ll start a 180-day timer, as well. You have 180 days from when you initiate the exchange to close on the new property. As long as your swap falls within this window, you’re good to go.
Do I always avoid paying taxes?
Unfortunately, the you don’t avoid taxes every time. Any cash you have left over, which is known as the “boot,” is taxed as a capital gain. So, if your property is worth $250,000 and you swap for a property worth $240,000, there will be a boot of $10,000. In this instance, you’ll be taxed for the $10,000 gain you made by selling your original property, because it was more than the property you swapped with it.
Again, remember we’re talking about a tax code. If you don’t follow the right rules, you may end up being taxed on the total value of your property. Now that we’ve answered your 1031 exchange FAQ, let’s go over how to do a 1031 exchange.
How to Do a 1031 Exchange
Between the 1031 exchange basics and some 1031 exchange FAQ, you may have a pretty good idea of how to do a 1031 exchange: find an intermediary, sell your property, identify a new one, and make the purchase. There’s one more thing we need to discuss about how to do a 1031 exchange, and it boils down to planning.
The difference in price can cause you issues regardless whether your starting property is valued lower or higher. For example, to avoid the capital gains tax if you’re selling a $200,000 property, the property you buy must also be $200,000 or greater. It’s rare that you’ll get someone to come down on a price simply because you don’t have cash on you to make a purchase.
Whatever difference it may be, you’ll either need to prepare yourself for a capital gains tax or prepare for a loan to fill the gap, which may push your timeline. If you’re figuring out how to do a 1031 exchange, you need to spend some time developing contingency plans, as well.
1031 Exchange Benefits
Whether success means selling at the top of a bubble into a property you expect to grow in value, or just diversifying your portfolio, it can be a powerful tool. You have opportunities to grow your wealth and defer your taxes as you grow as an investor.
The benefits of 1031 exchanges are great:
- Flexibility Between Property Types – Because what is considered to be “like-kind” property is fairly broad, there’s a lot of flexibility. It’s a great way to move between property types or get into another sector without financing.
- Delaying Your Taxes – As the value of your property increases, so does the tax. Being able to make investment moves without being burdened by taxes along the way is a huge relief.
- Capitalizing on the Market – If you know your market in and out, you may have a knack for predicting its movements. In that case, being able to move from one type of property to another—like a single-family residence to raw land—frees you up to move your money when you see the right opportunity for growth.
1031 Exchange Disadvantages
If you don’t plan ahead or underestimate the market, you definitely run the risk of putting yourself in a bad financial position. The 1031 exchange basics include a fair share of drawbacks.
There are clear disadvantages to 1031 exchanges:
- At the Market’s Mercy – Some markets just don’t aren’t active enough for you to swap for a property you want. Just because you want to swap properties doesn’t mean you’ll have the opportunity.
- Tight Timelines – 180 days seems like a lot. Between lining up potential properties and ensuring things don’t fall through, your first couple of exchanges may be a bit overwhelming.
- Inevitability of Taxes – Whether your target property costs less than yours or your property appreciates over time, you’ll probably end up paying capital gains tax at some point. The 1031 exchange is a tax tool, not a trick to avoid paying taxes forever.
With a solid understanding of real estate, this code can serve as a useful tool in your real estate investing career. You understand how to do a 1031 exchange, the 1031 exchange basics, and the 1031 exchange FAQs. Whether you take this out of your toolbox is up to you!