Should You Do a 1031 Exchange With Real Property?

Should You Do a 1031 Exchange With Real Property?

by Jared Lamp

If someone told you the IRS had a “best-kept secret”, you would want to know what it is, right? What if this “best-kept secret” particularly benefitted real property owners? Is your interest piqued yet? So, does this big secret of the Internal Revenue Code have a name? Yes: a 1031 exchange, and it could very well be one of the most powerful tools still available to taxpayers.

In it’s simplest definition, a 1031 exchange allows a real property owner to sell a property and replace it with a like-kind property, subsequently deferring all capital gains taxes as long as the IRS rules are followed. This is probably the most attractive aspect for real estate investors, since capital gains tax can suck 15% to 30% from your potential profits on a property sale. That kind of dent might make anyone wary of making future investments to expand their portfolio. In essence, if you continued deferring capital gains on your investment until you die, you would be avoiding them altogether.

The most important thing to keep in mind with qualifying for a 1031 exchange is that you are not selling a property, but “exchanging” it. Therefore, the property being sold and the new replacement property must be “like-kind” properties.

What Is a “Like-Kind Property?

There are currently only two types of properties which qualify as “like-kind”: property held for investment, or property held for productive use, i.e., a business. A few examples of real estate swaps that meet “like-kind” requirements would be an apartment building in exchange for an industrial warehouse, or a single family rental in exchange for a multi-family property.

1031 Timeline Restrictions

Within 45 days of selling the relinquished property, you must find the right replacement properties. There is no gray area with this 45 day rule. If you have not found a suitable replacement by 11:59 p.m. of the 45th day, there is no extension for you. In addition, you must also follow the “exchange period” which is also very strict. Here, the replacement property must be received within the exchange period ending within 180 days after the date which the property was released. Like the 45 day identification period, there is no extension offered.

Suitable Replacement Properties

You can find any three properties as potential replacements. The aggregate value of these three properties cannot exceed 200% of the value of the relinquished property. Also, you can choose any number of properties as long as you purchase at least 95% of the aggregate value of all properties selected.

The 1031 exchange has the ability to not only restructure and diversify your rental property portfolio, but the prospect of never having to pay capital gains taxes on a sale is motivation enough to get property owners excited and investigating it as an option. As with any major financial decision, you should consult a tax and legal expert to make sure it is the right move for you.

Do you have a success story related to doing a 1031 exchange? How about a failed attempt? Tell us your story today.

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