Basics and Rules of the 1031 Exchange in Real Estate

Understanding the Rules and Basics of the 1031 Exchange

In the world of real estate, there are many defining terms and factors to take into consideration before dipping your toes into the financial pool of real estate. If you have never heard of a 1031 exchange, to simplify it, it is a strategic tool when deferring tax on capital gains. Named after Section 1031 of the U.S. Internal Revenue Code, the 1031 exchange can be leveraged to sell an investment property and reinvest the proceeds in a new one, effectively postponing the tax liability.

Continue to read to find out the basics and rules of a 1031 exchange in the world of real estate.

What is a 1031 Exchange?

A 1031 exchange, aka a like-kind exchange, is a powerful tax-deferment strategy that is popular among experienced real estate investors. You can defer capital gains taxes on an investment property when it is sold–as long as the investor purchases another similar property with the proceeds of the first property sale. The term “like-kind” refers to the character or nature of the prospective property, not its quality. There is a wide umbrella of property types that would be considered to be like-kind. If the net market value of each successive property rises, an exchange into like-kind properties indefinitely.

How To Do a 1031 Exchange

It can be a daunting task to conduct a 1031 exchange due to the complex procedures and rules involved. With a clear understanding and a systematic approach, the process can be smooth. Follow the following steps to do a 1031 exchange:

1. Identify the Chosen Property for Sale. This type of property must be an investment property–not a residence–and it should ideally have been appreciated since purchased to take advantage of the tax deferment benefits of a 1031 exchange.
2. Engage in a Qualified Intermediary. Before your property is sold, it is important to hire a qualified intermediary (QI). This mandatory step is because the IRS doesn’t allow the seller to touch the money between the sale and the purchase of the new property. QI holds the funds during this period.
3. List the Property for Sale. Once your home sells, the proceeds go to the QI. Proceeds from this sale should not go to your bank account, or you may lose the 1031 exchange opportunity.
4. Identify Replacement Properties. From the date of sale, you have 45 days to identify up to 3 replacement properties as you wish, as long as the combined value does not surpass 200% of the sold property’s value. This has to be recorded in writing and delivered to the QI.
5. Purchase Replacement Property. From the day your initial property, you have 180 days to complete the purchase of any property or properties identified in the above-mentioned step. The QI transfers the funds from the initial sale to the seller of the replacement property.
6. File Form 8824 with Taxes. When filing for taxes for the year the exchange took place, include Form 8824 in your tax return, notifying the IRS of the exchange and informing them which property was sold and what property was purchased as part of the exchange process.

The 1031 exchange rules through the IRS are strict, so they should be followed closely. If done correctly, the 1031 exchange can be a powerful tool for building wealth through real estate investment.

Requirements for 1031 Exchange

The 1031 exchange is advantageous and bound by stringent regulations set forth by the IRS. To qualify for a tax-deferral strategy, specific criteria must be met while following certain rules. Failure to meet these requirements will result in disqualification from the 1031 exchange, leading to capital gain tax liability. You will want to familiarize yourself with the following 1031 exchange requirements if you are an investor:

• Like-Kind Property: All of the properties that are involved in the exchange have to meet qualifications as like-kind. They don’t have to be identical in regards to quality, per se. As long as it is held for productive use in a trade, real estate will qualify it.
• Investment Property Only: Personal residencies don’t qualify for a 1031 exchange, as the properties should be held for investment or used in a trade or business.
• Equal or Greater Value: To avoid paying any tax, the net market value and equity of the property acquired has to be the same as or greater than the sold property.
• Same Taxpayer: The tax return and name on the title of the sold property has to be the same as the tax return and title holder that buys the new property.
• Cannot Recieve Boot: The term “boot” refers to the additional value received in an exchange that isn’t like-kind property, like cash, debt relief, or property involvements.
• Reinvest Equity: When selling a property as part of a 1031 exchange, the equity received from the sold property has to be reinvested into the replacement property. If equity is pulled out in the course of replacement, you may be liable for taxes on any portions that are not reinvested.

1031 Exchange Rules and Timelines

The 1031 exchange process involves strict rules and timelines that have to be followed to defer capital gains tax. Below are great points to keep in mind regarding timelines and rules:

• 45-Day Identification Period. The 45-day identification period is the first significant timeline in a 1031 exchange. Within 45 days of selling the relinquished property, they must be identified for potential replacement properties, including providing a written list of up to three properties, regardless of their value.
• 180-Day Purchase Period. The second significant timeline begins the day that you sell your property and will last for 180 days. During this timeframe, you have to close on one or more of the properties identified in the previous step.
• Personal Use is Prohibited. You have to hold the replacement property acquired through a 1031 exchange for use in trade, business, or investment. Personal residences don’t qualify.
• Reinvestment Required to Defer all Taxes. To defer capital gains tax, you have to reinvest proceeds from the sale of the relinquished property into the purchase of the new property.
• Reverse 1031s are Possible. In certain cases, it is possible to purchase your replacement property before selling the property intended to be replaced. This is known as a reverse 1031 exchange and shares many of the same rules as a normal exchange.

Conclusion

When you adhere to timelines and rules, you can complete a successful 1031 exchange and defer capital gains tax on your chosen investment property. It is always advisable to consult with a tax professional for guidance throughout the process. Trust the professionals at Hendricks Team Realty to help you find your next 1031 exchange property in the many beautiful neighbourhoods that make up Niagara Falls, ON, today!