Maximizing Your Real Estate Investments with a 1031 Exchange
What if I told you that you could save 34% on your real estate investment, putting hundreds of thousands of dollars back in your pocket? Let’s dig into the 1031 exchange to learn how. Kristin and I are not just Real Estate Agents but also Real Estate Planners. As such, our goal is to help you build wealth through real estate by protecting, growing, and transferring it. The 1031 Exchange is an essential vehicle for people to achieve just that.
However, we must provide a quick disclaimer: we are not CPAs or real estate attorneys, and we don’t know your specific situation. Therefore, before taking any actionable steps, make sure to consult with those folks. And of course, if you would like to have a specific conversation about your real estate numbers, feel free to message us.
TABLE OF CONTENTS
What is a 1031 Exchange?
Let’s begin with what a 1031 exchange is. A 1031 exchange refers to Section 1031 of the IRS tax code and serves two main purposes. The first is to defer taxable gains on real property that you own. To illustrate, imagine you purchased a home a long time ago, and it has significantly appreciated over time. Then, suddenly, there’s a big gain between the price you paid for it and its current value. In this case, the 1031 exchange allows you to defer the taxes on that increase. The second purpose is to encourage real estate investors to reinvest that money into the US real estate market. This is to help stabilize values and increase property values nationwide.
What can you buy with the gains?
Now, this part is something we would like to address, especially for real estate investors. We’re talking about those who bought residential real estate and then moved out to let in renters, or those who own multi-family units or shopping malls. This strategy applies to you, even if you inherited the property.
The first thing you need to know is what you can buy with the gain. For instance, you bought a house for $100,000, and it’s now worth a million dollars. In this case, there is a big $900,000 gain. Now, the question is, what can you do with it?
According to the IRS code, you need to reinvest it in like-kind real estate. And this is where it may be confusing for some. That is because people assume that if they have a single-family house, they must purchase another single-family house. Or, if they have a duplex, they can only purchase a duplex or a shopping mall with a shopping mall, and so forth and so on. The good news is that it’s not that restrictive. It doesn’t necessarily have to be like that.
What exactly are "like-kind" properties?
Like-kind actually means deeded real estate. Therefore, you can take the proceeds from a single-family home and purchase a duplex. You can take the duplex and buy an apartment building. Or, perhaps, take the apartment building and buy a shopping mall. You can also invest in mineral rights and land—anything that’s real property and deeded qualifies as like-kind.
The only thing that does not qualify under the 1031 exchange is your primary residence. If you are living in the space, it does not qualify for this strategy. There are some caveats for things like owner-occupied duplexes or ADUs. However, that’s a more advanced tax strategy, so we won’t discuss that in this video. However, we will touch on it in a later video, so make sure to subscribe to our channel so you won’t miss any of the content we put out in the coming weeks.
Two Timelines to Remember When Doing a 1031 Exchange
The next thing to know about the 1031 exchange is that there are specific timelines related to it. It’s crucial to keep track of these timelines to ensure that you qualify for a 1031 exchange. If you fail to meet the timelines, you will not be able to use this strategy. So, here are the two main timelines that you need to keep in mind.
1. 45-day timeline to identify a property
First is the 45-day timeline to identify a property. What this means is that you have 45 days from the closing date of your property to identify the property or properties that you plan to purchase. During this time, you must identify a new property, or properties, with a total value of up to 200% of the value of the property you sold. For instance, let’s consider you have sold a property valued at one million dollars. You, then, can identify up to two million dollars worth of real estate as a potential replacement. However, you only need to close on one million dollars or more of the identified properties.
Moreover, you can identify multiple properties within this timeframe. This means you don’t have to limit yourself to purchasing a single property. To illustrate, let’s say you’ve sold a property for one million dollars. You could purchase four properties at $500,000 each, as they add up to $2,000,000. Therefore, there’s a lot of flexibility within this strategy.
2. 180-day timeline to close the property
The second timeline that you need to be aware of is the 180-day timeline to close the property. When doing a 1031 exchange, you have 180 days to close on the property or properties that you’re purchasing. This starts from the date of the closing of your relinquished property. It’s important to note that these two timelines—the 45 days to identify and the 180 days to close—run concurrently with each other. Therefore, it’s not 180 days from the date of identification. Rather, it’s 180 days from the closing of the relinquished property. And since this is an IRS tax rule, there is no leniency, so it’s crucial not to miss these deadlines.
The role of a Qualified Intermediary (QI)
The next obvious question is, “How would the IRS know if you’ve followed the rules?” Well, you need to use an impartial third party, similar to an escrow officer, called a Qualified Intermediary (QI). Almost every large bank and title and escrow office will have a qualified intermediary division. These qualified intermediaries are responsible for a set of things. First, they’re responsible for holding all the money. They take the funds so that they don’t go into your personal account. However, they instead hold them in a separate account and ensure that the money is reinvested properly. Second, they handle all of your documentation related to the 200% rule, the closing date, the 45- and 180-day time windows, and prepare all the necessary IRS documents. Third, they facilitate the transfer of money from your closing escrow to your new property’s escrow. They also handle all the logistics in between.
One crucial thing to note is that qualified intermediaries are not regulated or licensed, which is odd but true. So, it’s crucial to do your due diligence on these people and institutions. How are they protecting your money? What insurance do they have to ensure that your principal is protected? All of this diligence is quite important.
Three Rules When Doing a 1031 Exchange
So there are a couple of really important rules that you need to know when doing a 1031 exchange.
Rule No. 1: The property or properties that you’re acquiring need to be of equal or greater value to the relinquished property.
The first rule you need to know when doing a 1031 exchange is that the property or properties you acquire must be of equal or greater value than the relinquished property. If the value is less, then there will be a gap called a boot. Let’s say you’re selling for a million dollars and buying for $900,000. In this case, there is a boot. If a boot exists, you will be taxed on it. Therefore, ensure that you purchase properties that are of equal or greater value to avoid a boot.
Rule No. 2: Replacing the Debt
The second rule is that if you have any debt on the relinquished property, such as a $300,000 mortgage on the million-dollar property you sold, you must replace the debt. This rule is written in an interesting way, and most people are not aware of it. You can actually use new cash to replace the debt if you need to do so. This is especially true if you don’t want to obtain a new loan due to qualification issues. Or, perhaps, you are concerned about getting a FICO score hit or whatnot. However, it is important to discuss this option with your qualified intermediary, title and escrow officers, and CPAs before proceeding.
Rule No. 3: Putting the Proceeds into the New Property for Tax Deferment
Lastly, you have to put all the proceeds from the relinquished property into the new property. Always remember this if you want to take advantage of this tax deferral. So, you cannot take a part of it out, avoid taxes on that, and then put the remainder towards the new property. If you take some of it out, then you will be taxed on that amount. This part is again called a boot. Generally speaking, a boot refers to a taxable event where the IRS will claim some amount of money.
We hope you found some value in learning about 1031 exchanges. As you might have learned, they are a fantastic way to build wealth over generations. If you are interested in doing a 1031 exchange, please feel free to get in touch with us. However, always consult your CPA and tax attorney to ensure you are receiving the best advice.
WE hope our video on Maximizing Your Real Estate Investments with a 1031 Exchange has helped you.
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