1031 Exchange, Explained: How to Defer Capital Gains ‘Til You Die

Let’s say you bought a single-family home for $200,000, rented it out to tenants for a few years, and sold it for $300,000. That means you have $100,000 in profit, aka capital gains, burning a hole in your pocket.

You could either pay the capital gains tax rate on the $100,000, or…

Immediately invest those proceeds into a new vacation rental and defer the tax liability.

Which would you choose?

Investors who want to keep moving on up would pick the second route, and use a 1031 Exchange tax deference vehicle to do it. The process on the surface seems tricky and overwhelming, but walking away from the opportunity because it scares you means paying tens of thousands to Uncle Sam.

We spoke to Allison Simson, an investment property specialist and top-selling real estate agent in Summit County, Colorado, and Bradford Miller, owner of Bradford Miller Law, a 5-star law firm in Chicago that specializes in real estate transactions, to demystify the 1031 exchange once and for all.

What is a 1031 exchange?

A 1031 exchange allows investors to sell productive-use properties (meaning property you make money from, like apartments, rental homes, land, or office space) and buy another like-kind property (another investment property) while also deferring payment of capital gains taxes.

Let’s break this down. The government wants a piece of any “capital gains” (aka profit) you make from selling off assets like stocks, bonds or property.

Selling the home that you live in is a special case. Uncle Sam allows single filers to exclude up to a $250,000 capital gain on your home sale ($500,000 for married filers), meaning most sales of primary residences are completely tax free.

But that only applies if you’ve lived in the house for at least two of the last five years, so investment properties aren’t grouped into the exclusion. Without the 1031 exchange as vehicle for tax deference, the capital gains tax could cop up to 15% to 20% of an investor’s profit on the sale of an investment property, dependent on their tax bracket.

But hey, the government thought. Like homeownership, investing is another wealth-building activity that should be encouraged. So, 1031 exchanges are a special tax vehicle just for investment properties (and cannot be used for personal residences.)

What are the rules of a 1031 exchange?

The IRS has several strict rules for these types of exchanges:

  • You must use a qualified intermediary (QI) when doing an exchange, meaning you have to use a third-party company to hold your money while you purchase your next property. You cannot hold your money yourself, even if you cross your heart and promise not to spend it.
  • You must buy like-kind property. You can’t buy a personal residence through a 1031 exchange. You have to buy another investment property.
  • You have 45 days after you sell your property to find and identify up to three properties you’d like to purchase in the exchange. Then, from the closing date of the first property, you have 180 days to close on the new one, though most exchanges happen simultaneously.

What are the benefits of carrying out a 1031 exchange?

The biggest benefit to doing a 1031 exchange is deferring the capital gains taxes. It helps investors save a lot of their equity because that money doesn’t then go to taxes after the sale.

“The government wants to encourage investment so they allow investors to invest their entire proceeds into the next property,” Miller said. “This gives them more buying power and a better opportunity to keep moving up the real estate ladder.”

Plus, it incentivizes people to own second homes and encourages them to keep buying property—which boosts economic growth throughout the country.

What is “like kind” property in a 1031 exchange?

“Like kind” means properties with the same type of use. In the case of a 1031 exchange, “use” refers to the owners’ intent to treat both properties involved in the exchange as investments.

But don’t confuse “use” with property type.

Here’s what we mean: you can sell an apartment building to buy another apartment building. Or, you can sell an office building and buy an apartment building, as well; both would be considered investment properties that qualify for the 1031 exchange, so long as you plan to use them as such.

Can you exchange a property for multiple properties?

The rules of the 1031 exchange say that the number of properties you exchange doesn’t matter, so as long as the property value you’re exchanging for is higher than what you currently have.

So say you have a big house you want to sell. You could take the proceeds from the sale, and pour it into five different investment properties. You could also exchange three properties for two, so long as they are collectively higher in value.

The IRS doesn’t care about the number of properties; they just want to know you’re going up in value.

What is a Qualified Intermediary (QI)?

A Qualified Intermediary is a third-party person or company that handles money matters related to the sale and purchase.

Legally, the IRS does not allow you to hold the titles for two 1031 exchange properties, and the money you make on your sale can’t go into your own bank account. It needs to be held at an arm’s length, so that also means your personal attorney can’t be your QI.

When the sale of your investment property closes, all of that money goes into the QI’s account.

“The IRS wants to know it’s not being held by you or your family or your Uncle Bob. It’s held by the QI, and when you get ready to buy the other property, the QI buys it,” Simson explains.

What should you look for in a QI?

Get a Qualified Intermediary that’s insured, has a strong reputation, and that you know you can trust. There’s a lot of money and business dealings on the line with these exchanges, and you don’t want anything to screw that up.

Take the Breckenridge, Colorado, attorney Scoop Daniel, a QI who did a lot of 1031 exchanges and in 2007 vanished with $900,000 of his clients money. In 2012 he was sentenced to 12 years in prison.

1031-exchange
Source: (Fabian Blank/ Unsplash)

What is the cost of doing a 1031 exchange?

For a typical 1031 exchange, most Qualified Intermediaries charge about $750 to $1,250. That covers the cost to hold the money for the sale, hold the title, and do the closing. Reverse exchanges can cost about $5,000.

Is a 1031 exchange tax-free?

No. It’s not tax-free, but it is tax-deferred.

“People say if you’re taking advantage of the 1031 exchange, you should defer, defer, defer, and then die,” Simson said. “Because if you stop deferring, there’s a calculation, and you do have to repay some of the tax from all of this. Most of the time it works out that people keep deferring.”

What is a reverse exchange?

A reverse 1031 exchange happens when you find a property to buy but haven’t sold the old one yet.

Reverse exchanges are more complex, but a common solution for investors in a real estate market when housing inventory is low, and buyers have to act fast or risk losing the property they want.

The preferred reverse exchange method is known as “Exchange Last Structure.”

What happens is, a third party called an Exchange Accommodation Titleholder (EAT) would take title to the replacement property at closing and hold it on your behalf. If you have to finance the purchase of the replacement property, EAT becomes the borrower.

However, while the EAT holds title, the investor has total control of the property, covering all the expenses and collecting any income it generates.

You’d complete 1031 exchange at the time when your relinquished property closes. The proceeds from your relinquished property (sold by your QI) would be used to purchase the replacement property from EAT.

The challenge with this route is that lenders are wary about the EAT owning the property which the bank will use as collateral for the loan, so you may have to shop around to find a lender that is willing to work with you.

What is a delayed exchange?

A delayed exchange is a 1031 exchange that isn’t simultaneous. The IRS allows 180 days to close on a new property; if the sale and subsequent closing spread out over those days, that’s a delayed exchange.

“The pitfall is when people sell their first property and then the three properties they identified as a possible purchase all go under contract or sell out from under them,” Simson said. “The IRS does not allow for you to choose any other property. If you miss out, you’re hosed. You’re done. No 1031 for you.”

Can you use a 1031 exchange for swapping vacation homes?

In short, yes.

But, Miller says, “It depends on when you bought the property, what you invested into it, and other details of your ownership. Every property is different, so you would have to talk to your accountant about it.”

Some unique rules apply to vacation homes in this situation, as well. The IRS requires you hold a property for 24 months before exchanging it, and they want proof that you plan to rent (or at least try to rent) the new property.

As the property owner, you’re only allowed to use the home for personal use for 14 days or less, and you have up to 14 days allowed for maintenance on the property. You also need proof that you’ve rented out the property for at least 14 days per year.

In a 1031 exchange, what is “the boot”?

The boot refers to the difference in price if you use the 1031 exchange to buy a property worth less than the one you’re selling. You’re required to pay capital gains tax on that money.

Let’s go through an example.

Say you bought a beach house for $100,000 and sold it for $1 million. That’s $900,000 in capital gains. The 1031 exchange wants you to transfer all of that money into your next property. But if you don’t, say you only want to put down $500,000, the extra $400,000 you kept is the boot, and you’ll owe capital gains on that amount.

You can, however, lower the amount you’re going to pay taxes on, by accounting for things like sales commission, legal fees, escrow fees, transfer taxes, the title, and any of the other things that go with selling a property.

What is a real estate agent’s role in 1031 exchanges?

A real estate agent can help with a lot of the 1031 exchange process. It’s a partnership.

“My biggest role is telling people about it and letting them know this is a thing,” Simson said.

“In my experience, most people have heard the words 1031 exchange but they don’t know what it is or that they could qualify for it. It has this mystique around it, like it’s really advanced or you have to have a ton of money to do it. But you don’t.”

The agent will help you navigate the process, from getting the 1031 exchange agreement into the purchase contract to giving referrals for brokers and Qualified Intermediaries.

If you’re looking to do an exchange, find a real estate agent who has a Certified Investor certificate, or at least has taken some specialized 1031 exchange classes.

Start your search for a top real estate agent in your area with HomeLight, and ask the concierge to match you with a professional who has the experience you need to pull of a successful 1031 exchange.

Article Image Source: (Hal Gatewood/ Unsplash)

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