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Real estate investing can be a serious money maker for those who know how to play the game. Good properties appreciate over time, provide extra income and security, and allow you to claim depreciation on your taxes. But when it comes time to sell, unwary investors can be surprised to see how much they’ll need to pay in capital gains tax.
Due to their inherent price volatility, capital gains are generally associated with investments such as stocks and funds. But it can also be imposed on any security or possession sold for a higher price than when it was first bought, a clear nod to real estate appreciated over the holding period.
Fortunately, there is a way to defer capital gains through a 1031 tax exchange. Here, we explain everything a savvy investor needs to know about the 1031 exchange, what it is, what the rules are, and how to file for one successfully.
What is a 1031 Tax Exchange?What is a 1031 Tax Exchange?
Also known as a Like-Kind Exchange, a 1031 tax exchange is when an investor defers the capital gains tax on a property they’re selling by using the sale proceeds to purchase a new investment property. The exchange is meant to assist real estate investors in purchasing a higher-priced property after a sale.
For example, imagine an investor who has purchased a property for $700,000. A few years later, the investor sold this property for $800,000 so that they could buy a new property with that $800,000. Ordinarily, the investor would need to pay capital gains tax on the $100,000 profit they made on the sale, leaving them with less than they need to buy the new property. But under a 1031 exchange, they can defer that capital gains tax and use their entire $100,000 profit to purchase a new investment.
This allows an investor to swap their investment for a larger one without paying any tax due at the time of the exchange. When used correctly, there is no limit to how often you can file for a 1031 exchange, allowing savvy investors to continue rolling their gains from one investment into another over many years. If everything goes according to plan, you’ll only pay one tax at a long-term capital gains rate (currently 15% or 20% depending on income levels – or 0% for some lower-income taxpayers) when you finally cash out for good.
1031 Exchange Timelines and Rules1031 Exchange Timelines and Rules
While the term “1031 exchange” gets bandied about by real estate agents and investors, both large and small, there are many moving parts and limits on its use. Consider the following before moving to file a 1031 exchange in NYC:
1. The Properties Must Be “Like-Kind.”1. The Properties Must Be “Like-Kind.”
According to the IRS, filing for a 1031 exchange requires that both the relinquished property (the one being sold) and the replacement property (the one being bought) must qualify as “like-kind,” which is defined as “having the same nature, character, or class.” It doesn’t matter if the properties differ in quality or grade; they are both real estate properties. For example, a single-family residence would be considered like-kind to an office building.
The IRS is fairly lenient on their definition of like-kind, but they draw a line regarding property outside the United States. For instance, an apartment building in Brooklyn would not be considered like-kind to an apartment building in Canada.
2. Equal or Greater Value2. Equal or Greater Value
To defer all your capital gains tax, the replacement property must be of equal or greater value than the relinquished property. If you’re selling a property for $1 million, the IRS requires that the new property have a (net) market value of at least $1 million. In addition, the mortgage amount on the replacement property must equal or exceed the mortgage paid off at the sale of the relinquished property.
3. Can’t Touch the Cash3. Can’t Touch the Cash
All proceeds from the sale of the relinquished property must be held in an escrow account by a qualified intermediary (more on that below). These funds can then only be used to purchase the replacement property. The buyer cannot handle or withdraw these funds into a personal account, even not temporarily.
4. Qualified Intermediary4. Qualified Intermediary
The IRS requires a qualified intermediary, or “QI,” to complete the exchange. Their job will be to draft the necessary legal documents for a 1031 exchange, hold the escrow funds from the sale of the relinquished property, and ensure that the exchange is followed under all IRS rules. Often, what sets a smooth, problem-free 1031 exchange apart from a nightmare scenario are the qualifications and capabilities of the QI.
Be aware there are no licensing requirements for QIs; they only need to be considered not unqualified as defined by the IRS. Therefore, when choosing a QI to work with, make sure they are someone you can trust, that they understand the nuances of your particular 1031 exchange, and that they have proven experience. You’ll also want to sign a 1031 contract agreement with them.
5. Investment or Business Properties Only5. Investment or Business Properties Only
This rule trips up most people attempting to file for a 1031 exchange. The rule says you cannot exchange primary residences, only investment or business properties. Fortunately, there is a silver lining to this rule. You can, under certain conditions, exchange a former primary residence.
For a time, you could also exchange a rental property for a vacation home, but Congress tightened this loophole in 2004. The only way an exchange like this will get past the IRS is if the vacation home has been de facto converted into a rental property.
6. Same Taxpayer6. Same Taxpayer
The buyer of the replacement property must be the same legal entity as the seller of the relinquished property. Whether you’re an individual owner, a joint owner, or an LLC, the rule is the same, all titles and deeds must match the same name.
7. The Boot Rule7. The Boot Rule
While the Equal or Greater Value Rule still stands, performing a 1031 exchange of lesser value is possible. This is the Boot Rule, with “Boot” referring to the difference in value between the relinquished and replaced property. That difference is taxable. You’ll usually see investors use this rule when they want to make money off a deal and are okay with paying some taxes.
8. 45-Day Rule8. 45-Day Rule
Once a seller has closed on the relinquished property, they have no more than 45 days (calendar, not business) to designate the replacement property. This can be challenging as it is not always easy to find a like-kind property of equal or greater value in a limited time. To clarify, you don’t need to close on the replacement property within this timespan; you need to identify it.
To make things a little easier, the IRS allows you to designate up to three properties; all you need to do is eventually close on one of them. There is also a subrule, the 200% rule, which says you can designate more than 3 replacement properties so long as their combined value does not exceed 200% of the sales price of the relinquished property. Another subrule is the 95% rule, which allows you to designate any number of properties, regardless of their sale price, so long as you can close on only 95% of the value identified.
9. 180-Day Rule9. 180-Day Rule
IRS regulations state that your replacement property must close within 180 days of the closing of your relinquished property or the due date of the tax return for that tax year when the property was sold (whichever is earlier). Put another way, if the 180-day limit comes after taxes are due, the exchange must close by the tax due date.
10. Reverse Exchange10. Reverse Exchange
You can also purchase the replacement property before selling the relinquished one and still qualify for a 1031 exchange. The same rules and timelines still apply, just in reverse. For instance, you would need to transfer the replacement property to an exchange accommodation titleholder, identify a property for exchange within 45 days, and then complete the sales transaction within 180 days.
New York’s 1031 Exchange Rules and RegulationsNew York’s 1031 Exchange Rules and Regulations
In New York, the rules and regulations for a 1031 exchange are similar to the rest of the nation. However, one notable exception will apply to investors who aren’t residents of New York when they file their exchange. Nonresidents filing for a 1031 exchange will be subject to a 7.7% state income tax on any profits realized from their sale.
Fortunately, it’s quite easy to avoid this. You must apply for a New York State tax exemption by filling out Form IT-2663. This indicates that a like-kind exchange is taking place, which will exempt you from a tax.
How Could a 1031 Exchange Benefit Me?How Could a 1031 Exchange Benefit Me?
The main benefit of a 1031 exchange is the tax deferral. By deferring capital gains tax, you can free up more capital to put into a new investment that you couldn’t have afforded previously. In the short term, this nets you a bigger and better property. But the benefits of a 1031 exchange are even greater in the long term. By continuing to exchange properties, you can keep deferring your capital gains tax while building your wealth and rental income to greater heights.
However, it’s important to remember that the complexity of 1031 exchanges and the need for a comparatively high minimum investment and holding time make these transactions ideal for experienced investors with a high net worth. As such, they’re better avoided by beginner investors.
How to File for a 1031 Exchange with the IRSHow to File for a 1031 Exchange with the IRS
To begin a 1031 exchange, you must report it by completing IRS Form 8824 and filing it alongside your federal income tax return. When filling out the form, you will be required to provide descriptions of the properties being exchanged, the dates when they were identified and transferred, any relationship you may have with the other parties, and the value of the like-kind properties. For each new exchange, a new Form 8824 must be completed.
You must complete the form in full and without error. If the IRS believes you haven’t adhered to the rules, you could be hit with a serious tax bill and penalties. To reduce the likelihood of this happening, the IRS provides line-by-line instructions on how to complete form 8824.
Final ThoughtsFinal Thoughts
A 1031 exchange can be a killer way for savvy investors to defer their taxes while also building their wealth. However, the complexity of the process and its many moving parts can leave a lot of room for error. Investors considering filing for a 1031 exchange are highly advised to ensure they fully understand the rules and have professional help to guide them. That goes for all investors, even seasoned ones who know their way around the local market.
Form 8824 for 1031 Exchange – DownloadForm 8824 for 1031 Exchange – Download
File form 8824 below with the IRS when your file taxes and required state tax documents.