Are you in the plan to be an investor? Do you wonder what the 1031 exchange rules are? Well, then read ahead! Here we will inform you everything you need to know about these rules.
Many 1031 exchange rules need to be followed when one wants to be an investor. The main reason people do it is to delay the Capital Gains Taxes. The term comes from the Internal Revenue Service (IRS) Section 1031.
1031 exchange is only possible when the swap of the properties is done for investment or business purposes. Also, it must be a like-kind exchange as well so that you can defer the taxes.
Furthermore, if a person can use the 1031 exchange correctly, they can make as many investments as possible.
5 Ways to Understand the 1031 Exchange Rules
#1 IRS, Like-Kind, and 1031 Exchange
Like-kind exchange means when the investor buys a property used for business or investment and then uses it for the same purpose. This rule was permitted in 1921 under Section 1031 of the Internal Revenue Code.
#2 Three Important Rules of 1031 Exchange
When you want to be an investor who plans to do a 1031 exchange, you need to plan before you start it. Here are the three most vital rules of 1031 exchange that one must know:
Firstly, the replacement property must be of either equal or more value than the previous property.
Secondly, the replacement property needs to be identified within six weeks or 45 days.
Lastly, you should buy the replacement property within six months or 180 days.
#3 Eliminate the Capital Gains Tax Forever
1031 exchanges allow delaying the taxes. But what will happen if the investor dies or the property is passed to the heir? Then the value of the property is increased. Now it is fair market value, and all the deferred taxes gets eliminated.
#4 Recognize the Eligible Properties
According to the IRS, a property is a like-kind exchange when the characteristics are like one is being replaced, even when the quality is not equal. They consider the properties to be like-kind irrespective of how the rules of real estate have changed and improved.
For instance, an investor can swap a small building for a bigger project, a vacant land, or for any office building.
#5 Five Common Types
The real estate investors use mainly these five types of 1031 exchanges. These are:
Delayed or simultaneous exchange
It happens when you buy the replacement property at the same time when the current asset is selling.
Simultaneous build-to-suit exchange
It is when the build-to-suit properties are bought before the old one is sold.
When a property is relinquished or sold, and the replacement property is bought within the allowed time.
Delayed build-to-suit exchange
When the current residence is replaced with the new one, a built-to-suit needs an investor is known as delayed build-to-suit exchange.
Delayed reverse exchange
When a replacement property is bought before the current one is relinquished is known as a delayed reverse exchange.
1031 exchange for dummies
The 1031 exchange is very complex. Moreover, there are numerous guidelines, deadlines, and rules that one needs to follow to qualify as an investor for 1031 exchange investors.
Furthermore, the most important thing you need to know first is the type of transaction that qualifies. Now you can delay taxes that are like-kind exchanges. This applies to both business or investment properties that the investor wants to exchange for different properties.
Also, there are a lot of ways that are under the IRS like-kind. For example, investors can sell a mansion and buy small apartments. However, you need to use the properties for either investment or business purposes since residential properties don’t qualify.
If the investor uses these properties as a residential house, they cannot gain the benefits of the 1031 exchange. IRS code has stated that houses held for sales are not eligible, which applies towards house flipping.
Moreover, properties you will use for business or investment purposes like a warehouse or rental qualify for the exchange. With 1031 exchange, you are investing your earnings from old properties into a new property.
1031 exchange examples
Three examples of the 1031 exchanges:
#1 Add more money when you are buying
So the investor sells a property for $70000 and then had a $50000 mortgage during the time of sale.
Now you want to buy a new property that is $90000 but wants to keep the same debt level. Hence, the investor will add $20000 from their own earning and purchase the new house with a $40000 mortgage and $50000 in cash. And this will follow all the 1031 exchanges and also can defer the taxes.
#2 Increase the Leverage
The main reason for the 1031 exchange with investment properties is so that it can increase leverage. Also, the investor will put their own money in the process for a high-income property. Not only the cash flow will increase but also the rate of the building equity.
An example: The investor disposed of one of the investment properties for $500000 and owned $100000 on the mortgage while selling.
Now the investor is looking at a property that is $1 million, so now they will use $400000 in cash and add a $600000 mortgage to buy this new property.
This also falls under the 1031 exchange, and they can defer taxes.
#3 An incomplete 1031 exchange
A lot of investors do a partial exchange. But if they purchase the property at a lower rate than the original price, then a small amount of the property’s sale price will be taxable. The rule that is also applicable is they choose to take less debt with replacement properties.
For example, they sell a property for $600000 when they have a $300000 mortgage. Now they can purchase a property that costs $500000 that also with a $300000 mortgage. The $100000 that they receive is the taxable income.
Hence the investor can defer taxes on bulk during the first property sale. However, they need to pay Capital Gains Tax if the money did not get rolled while purchasing the new property.
1031 exchange rules primary residence
1031 exchange involves only investment properties. However, your primary property is not eligible for any 1031 exchange. Also, your second house where you have lived for some time will be ineligible unless you do not treat it as an investment asset for tax purposes.
Also, if you have used any of your properties for rental purposes, such as Home Away or Airbnb, you can use it under Section 1031 and Section 121.
Another thing you need to know is that you can make your primary house into the former house, and then you can continue with the 1031 exchange for tax-deferred.
1031 exchange rules 2021
There are several 1031 exchange rules you need to follow if you want to profit from deferring the tax accountability when there is a sale of a real estate property.
Furthermore, if you plan to do a 1031 exchange, the money you earn from the sale will be held in escrow. It is an independent account that a third party manages. You cannot access that money unless you close on another property. Also, you cannot use this money for anything else.
Some of the 1031 exchange rules are:
#1 180 Days till the transfer done
Just after a sale, you need to look for a new property. Within 45 days, you need to find a new property that you want to purchase. Once you select the replacement property, you will get 180 days (6 months) to close on the replacement assets.
However, closing a property takes a lot of time and sometimes can be unpredictable. Hence most of the investors buy multiple properties in hopes that one might come through.
#2 Flipping Real Estate not regarded as 1031 Exchange Properties
Both the old and new properties have to be underinvestment, business, or trade to qualify as a 1031 exchange. If you hold any investment, that means holding it for future use. Whereas, for business or trade, it means for income-producing like using as a rental property or in a business. Fix, and flip types of properties are the properties that are going for sale.
It also falls under 1031 exchange rules if you rent it for some months before selling the property to an investor.
#3 Like-kind Property
If you want to do 1031 exchanges, then choose like-kind property. However, you will find the rules for the like-kind property evolved over the years. In 1984, 1031 exchange rules changed, and due to it, like-kind property rules also expand a lot. Now people have the option to sell any rental residence and purchase small apartments.
Before it changed, the investor did not have to exchange a residence for residence but a 3-story apartment for a 3-story apartment. Moreover, the buildings do not need to in the same place. For instance, now the investor can sell an apartment and then invest it in industrial property.
Furthermore, domestic and international property exchange does not fall under the 1031 exchange. But any property in the USA falls under the 1031 exchange.
Besides, you need to find the right property to reinvest. If you can’t, then do not do the 1031 exchange.
#4 Personal Houses is not under 1031 Exchange
An investor cannot sell their house then use that money to purchase a rental. Moreover, you would consider a house a personal residence if the investor lived for two years in the last five years.
Furthermore, second home or vacation houses do not count as 1031 exchange either.
#5 45-Days’ Time Limit
Within 45 days, you need to find a new replacement property. You need to identify or close on and then report it 45 days or six weeks of selling the previous property. Moreover, the period also includes holidays and weekends.
If you cannot do it within the time limit, then the exchange will be disqualified. Also, now you need to pay taxes as per the value of the old property.
1031 exchange time limit
If you want to get the maximum benefit of the 1031 exchange, then the replacement property must have an equal or more evaluation. You need to choose a replacement property and sold it within six weeks (45 days) and then complete the exchange within six months (180 days).
Furthermore, there are three rules which you might apply for the identification. You must meet one of the rules:
#1 200% Rule
This rule will allow you to recognize unlimited replacement assets. The cumulative value should not extend more than 200% of the total value of the property sold.
#2 Three Property Rule
This rule will allow you to recognize three possessions as potential buying irrespective of the market value.
#3 95% Rule
This rule will allow you to recognize as many properties that you like. But the value of the acquired properties should be 95% or more than the total.
1031 exchange 5-year rule
When the property is purchased by the 1031 exchange and if you change it in the future into a primary house, you must keep the assets minimum for five years. If you do not do that then, you will have to pay tax for it.
1031 exchange intermediary
Qualified Intermediary (QI) or Accommodator is a separate party that involves in the like-kind exchange and tax-deferred. They help the disposition of the exchanger’s properties and then take the exchanger’s extra property as per the agreement.
Moreover, the QI does not have money except for the compensation or fee. According to the Treasury Regulations, this is the correct process when dealing with taxes which falls under the 1031 exchange rules.
IRS 1031 exchange rules 2021
IRS 1031 exchange rules provide an exclusive offer and allow people to delay paying taxes only if they reinvest the earnings in similar assets. And this is part of the qualifying like-kind exchange.
Furthermore, you can postpone your taxes in the like-kind exchange under the IRC Section 1031; however, it will not be tax-free.
A 1031 exchange is mostly in use by investors in the real estate business and want to delay their taxes. Investors can only use the properties for either business or investment purposes. Also, it must follow the like-kind exchange as well.