Building Real Estate with the 1031 Exchange
The IRS has created a number of advantageous tax strategies for real estate investors, but the one that provides a long term strategy is the Like-Kind Exchange (1031 Exchange). The IRS says: “Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-freei.”
Who qualifies for the 1031 Exchange?
Owners of business and investment property may qualify for this deferral of capital gains taxes when selling a property and reinvesting per the rules in another like-kind property. All entities qualify:
- Sole proprietorships
- LLC, Limited Liability Companies
This is not an avoidance of paying capital gains, instead it is a deferral of the taxes until the final disposition of the property.
What does a Section 1031 Exchange look like?
To qualify for this tax treatment, there must be an exchange of two like-kind properties. For real estate investors, it is liberal. A rental home can be exchanged for investment land, or other real property. The most common approach for real estate investors is to sell rental properties and roll the proceeds into other rental properties, constantly growing their net worth while deferring capital gains taxes.
The process is not as simple as just selling one property and buying another. There must be an integrated transaction that constitutes an exchange of property. Due to the strict rules and timelines to qualify, most investors use a 1031 Exchange facilitator to oversee both transactions according to the IRS rules.
When the first property is sold, the time limit of 45 days kicks in for the identification of the replacement property. This must be a signed document clearly setting out the replacement property, and the document is delivered to the facilitator. This facilitator or qualified intermediary must be involved in or control all aspects of the exchange.
The replacement property could be multiple properties as well. Some rental investors will sell a rental home at a nice profit and roll the proceeds into two or more good rental properties. Another deadline is that the completion of the exchange must be within 180 days of the sale of the exchanged property.
Strict rules for computation of basis must be followed:
Capital gains tax is deferred, not forgiven. For this reason, it is critical to follow IRS rules carefully to calculate the basis in the new property acquired. This is so that the deferred and accumulating capital gains can be properly taxed later when final disposition of the property is completed. It is crucial that the investor works with an experienced facilitator that will fully comply with all IRS rules.
This information is a broad overview of a complicated process that must be done properly. The good news is that real estate investors can keep rolling profits in properties over into others for decades, growing their net worth significantly. Even better, until the IRS changes rules, you can die and take it with you!
Well, really the way that works is that if you are holding all the properties when you pass, they were never disposed of, and the capital gains taxes simply disappear. Your heirs inherit the real estate at its stepped-up value!