Real Estate: 1031 Exchange Examples

Woman working on a 1031 exchangeWhen investors want to diversify their portfolios, they often consider real estate. But if you’re interested in real property, you need to know the ins and outs of purchasing and selling. One method many investors rely on is called a 1031 exchange. By following the rules for this type of exchange, investors can defer their capital gains tax while working towards better and bigger properties. Understanding how a 1031 exchange works is crucial to its success, though. Here are a few example scenarios to help you get familiar with it.

Taxes and real estate can get confusing. Consider working with a financial advisor as you work to make sure your real estate investing is as tax efficient as possible.

What Is a 1031 Exchange?

A 1031 exchange is a tax-deferment strategy often used by real estate investors. In this process, the owner of an investment property (or multiple) sells their original property and buys a like-kind property as a replacement. By following the IRS’s rules during this procedure, they defer capital gains tax.

A like-kind property exchange doesn’t mean you need to swap the exact same type of building. They also don’t need to share the same quality, only their character or class. For instance, a vacant lot is like-kind with a real property improved with a rental building. You can tailor your exchange to meet your goals and needs as long as it meets the requirements laid out in Section 1031. However, investors should note that real estate within the U.S. cannot be like-kind with any property outside the country.

The process also requires the use of certain channels. Namely, you need an exchange facilitator. According to the IRS, this is a “qualified intermediary, transferee, escrow holder, trustee or other person that holds exchange funds for you in a deferred exchange” under the applicable terms.

There are also four different types of 1031 exchanges: simultaneous exchange, delayed 1031 exchange, reverse exchange and improvement exchange.

1031 Exchange Examples

A 1031 exchange requires you to fulfill two crucial rules.

First, there is a minimum value requirement. The new property, or properties, must have a purchase price equal to or more than the amount you sold your real estate for. So, if you sell your property for $600,000, then you must buy a replacement property worth at least that much.

The second requirement applies to financing. Essentially, anyone with a loan on their original property must carry the same amount of debt or more with the replacement property.

Here are some examples to illustrate how a 1031 exchange works.

Example 1: The Basics

Tax payer preparing to pay capital gains taxSuppose you are a real estate investor. You choose to sell your current property with a $150,000 mortgage on it. It sells for $650,000. If you want to meet the conditions for a 1031 exchange, you much purchase a replacement property for at least $650,000. In addition, you need to borrow a minimum of $150,000 to pay for it.

Sounds straightforward, right? But we all know the real world is a little more complicated than this. The following examples show you how the situation may change.

Example 2: Higher Value Replacement

It’s unlikely you’ll find a replacement selling for exactly the same amount as your original property. With that in mind, let’s say you sell your property with a $300,000 mortgage on it for $500,000.

While searching for a replacement, you find a property you want to buy. But it’s valued at $700,000. In that case, you contribute $200,000 out of pocket and purchase the replacement with a $300,000 loan and $400,000 of cash. Like this, you can still defer taxes since you satisfy the two basic requirements.

Example 3: Increased Leverage

One concept in real estate is known as leveraging. Basically, it means using debt, such as a loan, to buy an asset, like property. Investors can increase their leverage using a 1031 exchange, allowing them to invest in a higher-value property. As a result, they can not only improve their cash flow but multiply the rate they build equity at.

So, suppose you sell one of your first investment properties for $500,000. You still owed $100,000 on the mortgage at the moment of sale. But you want to set your sights higher. As a result, you move to purchase a property that costs $1 million.

You use the total profit from the sale at $400,000 and take out a new loan worth $600,000. With this, you meet the 1031 exchange requirements.

Example 4: Partial 1031 Exchange

It’s actually possible to sell an investment property and satisfy the 1031 exchange rules without using all of your sale proceeds. This is called a partial exchange. However, buying a replacement for a lower cost than the original property’s sale price or taking out less financing will result in taxes.

For instance, we’ll say you sell your original property for $650,000. It had a $200,000 mortgage leftover. You then purchase a property for $500,000 but still take out $200,000 for the loan. The $150,000 in profit unused becomes taxable income.

Essentially, you still defer taxes on the better part of the sale from the first property. But the money that you didn’t put into the replacement still faces capital gains tax or depreciation recapture.

The Takeaway

Aerial view of a plot of real estate

A 1031 exchange comes with a few advantages, including deferring capital gains tax, expanding your portfolio and more control during the sale of property. And the way you go about your exchange can vary depending on your goals and needs. Before pursuing a 1031 exchange, research the requirements in depth and consider speaking to a financial advisor. Similarly, any investors interested in real estate should do the same. A financial professional can guide you through the rules and consequences which could impact your future investments.

Tips for Investing 

  • Many investors use real estate, whether through REITs or physical property, to diversify their portfolios. However, you may want guidance before you change your investing strategy. If so, consider speaking with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • You may already be making strides to reach your retirement savings goals, complete with a strategized investment portfolio. Perhaps you even have an emergency fund safety cushion prepared for sudden changes. But maybe it’s time to diversify, earn greater returns or a passive income. In that case, real estate might be your golden ticket. Just research the historical trends and expected performance beforehand.
  • Most advisors recommend having a diversified portfolio. Adding real estate can offer additional diversification and non-correlated assets to your portfolio. Our asset allocation calculator can help you determine how much of your portfolio to invest in real estate.

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A Simple Trick for Avoiding Capital Gains Tax on Real Estate Investments

Aerial view of a farmInvesting in real estate can assist you in diversifying your investment portfolio by adding physical assets and providing you with a hedge against inflation. If you are a real estate investor, or if you aspire to become one, you will want to know about like-kind exchanges because they give you a chance to shift your real estate investments on a tax-deferred basis. Like-kind exchanges give you the opportunity to have a dynamic real estate portfolio that you can adjust based on the market and the economic conditions without incurring a large tax liability. Here is how they work.

If you’re looking for counsel on diversifying your portfolio or adding physical assets to your holdings consider working with a financial advisor.

Like-Kind Exchange, Definition

A like-kind exchange happens when an investor wants to sell real estate and avoid the capital gains tax that would normally be assessed. The investor can use the like-kind exchange to sell a parcel of real estate and buy another parcel as long as the parcel they buy is similar to the parcel they sell. A like-kind exchange is authorized as a Section 1031 exchange under the Internal Revenue Code (IRC). Both the like-kind exchange and like-kind property are defined under Section 1031.

Like-kind property is composed of real estate assets that are so similar in nature that they qualify for a like-kind exchange. The Internal Revenue Code defines a like-kind property as any held for investment, trade, or business purposes under Section 1031. Grade of the assets or quality of the assets is not used to determine like-kind property. Personal property cannot be used in a like-kind exchange. The gains of the transaction are not tax-exempt. They are tax-deferred.

Section 1031 of the IRS Code exempts the seller of the property from paying capital gains as long as the property is for business and investment purposes. The seller must purchase like-kind property every time they sell property in order to defer taxes for the longest time period possible.

Like-Kind Exchange, Types

There are four types of like-kind exchanges:

  • Simultaneous – The simultaneous exchange is reasonably simple. It is the simultaneous exchange of one qualifying property for another with the transaction closing that day.
  • Deferred â€“ The deferred exchange may be the most common. The seller sells the property and has 45 days to identify the property that will be exchanged for it. Then, the seller has 180 days to complete the sale. An exchange facility is often used to facilitate the deferred exchange to be sure it doesn’t become a taxable event.
  • Reverse â€“ A reverse exchange occurs when the property that will be the replacement property is acquired and the seller has 180 days to sell the original property.
  • Improvement – An improvement exchange requires that the property that is acquired be placed with an intermediary for 180 days while construction or improvement occurs.

Like-Kind Exchange, Conditions & Rules

Real estate concept graphicSeveral conditions must be met for a property to qualify for an exchange. The property must be used in a trade, business or investment. Personal property does not qualify. The property must be like-kind to the property it is replacing. Usually, real estate is like-kind to other real estates as long as neither parcel is for personal use. Using an exchange facility for the transaction helps ensure that a mistake is not made regarding the personal property issue.

There are also a set of rules that must be followed when doing an like-kind exchange.

  • When the replacement property is finally sold, that’s when the tax on the capital gain is paid.
  • Only business or investment property can be exchanged as of the enactment of the Tax and Jobs Act of 2017.
  • The exchange must be identical in nature.
  • The replacement property must be of the same or higher in value.
  • The owner of the original and replacement property must be the same person.
  • The property must be acquired in 45 days and the transaction closed in 180 days.

The Bottom Line

Model houseReal estate investors, dealing in frequent real estate transactions, should take advantage of like-kind exchanges when they can. Since real estate is usually like-kind for other real estates, the rules may not be as hard to follow as it appears. The most difficult issue may be the relatively short time frames to complete the acquisition and closing the deal.

Tips on Investing

  • Investors contemplating a like-kind exchange should carefully think through the pros and cons. That’s where a financial advisor can be invaluable. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you’ve decided to craft your investment portfolio alone, you should make sure you’re prepared. SmartAsset has you covered with a number of different online investment resources to help you figure things out. Check out our free asset allocation calculator today.

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Here’s a Trick to Take Control of Your Taxes in an Unpredictable Real Estate Market

Real estate investors discussing a reverse 1031 exchangeMost real estate investors are familiar with traditional tax-deferred exchanges. They require you to sell your current business property before you can purchase another. However, there’s an alternative route that allows you to take some extra control in the unpredictable real estate market. A reverse 1031 exchange is a tax-deferred method that provides a variety of potential benefits. But it requires a careful strategy and knowledge of legal guidelines. Here’s what you need to know about them before diving in.

Consider working with a financial advisor as you seek ways to handle real estate matters in a way that minimizes taxes. 

What Is a Reverse 1031 Exchange?

A reverse exchange is a maneuver that investors employ in real estate. This type of property exchange involves purchasing a replacement property before selling or trading the currently owned property. The investor must sell or transfer that original property, though, since owning both at the same time (or a “pure” reverse exchange) is not allowed.

But there are other types of 1031 exchanges as well. For example, there is the most common form, called “forward 1031 exchange.” Otherwise known as a like-kind exchange, delayed exchange or starker exchange, it describes selling and closing the original property before finalizing the purchase of a new property. There is also:

  • Simultaneous exchange: when you purchase the replacement property and sell the current property at the same time.
  • Delayed build-to-suit exchange: when you replace the current property with a new property built to match the investor’s needs.
  • Delayed/Simultaneous built-to-suit exchange: when you buy the built-to-suit property before transferring the current property.

Reverse exchanges solely apply to Section 1031 property, which usually must be investment or business property. The regulation may also apply to a previous primary residence or vacation home, but only when meeting very specific conditions.

However, while you can expedite the process, you can’t take ownership of the replacement property immediately. You have to complete the entire transaction first. Until the sale of the relinquished property, an intermediary called the exchange accommodation titleholder (EAT) must hold the property. Parking the property with an EAT is called a qualified exchange accommodation arrangement (QEAA).

Structure of a Reverse 1031 Exchange

There are two ways you can format your reverse 1031 exchange. They are:

Exchange First Reverse 1031 Exchange

In this case, the EAT takes the title of the relinquished property before the investor purchases the replacement. The price is based on the estimated fair market value; however, the investor provides the funds to the EAT. But you maintain control over the property when you sign a QEAA and lease.

The EAT then also takes possession of the replacement property.

Within 180 days of the EAT taking the replacement property’s title, you must close the relinquished property’s sale. You then receive these proceeds as reimbursement for the funds you gave to the EAT to buy the relinquished property.

Exchange Last Reverse 1031 Exchange

Here, the EAT takes possession of the replacement property as soon as you close on the purchase. You provide the funds to do so, although the EAT is named the borrower on any financing.

Within 180 days of this purchase, a qualified intermediary sells the relinquished property on your behalf. Then the sale proceeds are used to buy the replacement property from the EAT.

Afterward, the EAT transfers the replacement property title to you, and the qualified intermediary transfers the relinquished property sale proceeds to the EAT. Finally, the EAT uses said funds to pay off any existing debt from the replacement property purchase.

1031 Exchange Time Periods

Generally, an exchange occurs when you swap one property for another. But it’s not easy to locate the exact type of property you want, which can mean delays. Two timing rules apply to the 1031 exchange, though.

The first is the 45-day rule. Once you sell your property, you need to identify the replacement to your intermediary within 45 days. It should be in writing and detail the property you want. Investors can designate three properties as long as they choose one to purchase. It’s possible to designate more than the base three sometimes, although it depends on their valuation.

The second is the 180-day rule. Simply, you must close on your new property within 180 days of the old property’s sale.

Reverse Exchange Key Timing Considerations

Tax documents, calculator and model of a houseSo, the timeline for reverse exchanges mirrors the deadlines used in a deferred exchange. If you fail to meet the 45- and 180-day deadlines, you don’t lose or disqualify the transaction. However, you will no longer be able to enjoy the benefits available through the presumption of the safe harbor. Anyone participating in a reverse 1031 exchange needs to keep these time period tweaks in mind:

  • 45-Day Deadline: The exchanger must communicate with the EAT in writing and identify the properties that may be relinquished. This is done prior to or on the 45th day following the EAT’s acquisition of the target property.
  • 180-Day Deadline: The EAT must transfer the replacement property to the exchanger, or the current, relinquished property to a third party. This must be done on or prior to the 180th day after the EAT acquires the target property.
  • Concurrent Deadlines: Both the above deadlines run at the same time. Also, the 180-day parking period (exchange last reverse) and the 180-day exchange period are independent of each other. 

Like-Kind Property in a Reverse Exchange

Section 1031 of the IRC requires any investment real estate involved in a 1031 exchange to be “like-kind.” According to the IRS, like-kind exchanges are “real property used for business or held as an investment [exchanged] solely for other business or investment property that is the same type.” So, its character defines it rather than its grade or quality.

The range of exchangeable real estate is broad as a result. For example, you can exchange vacant land for a commercial building. However, you can’t swap real estate for another tangible asset, such as gold or artwork. Usually, exchangers must have owned the property for a minimum of two years. Finding a replacement property with equal or greater value will also help you receive the full benefit of your 1031 exchange.

Purchasing a property with lesser market value incurs taxes on the remaining income made from the relinquished property sale.

There are three rules that you can use to designate your replacement property. They are:

  • The three-property rule: identify three properties for possible purchase, no matter their market value.
  • The 200% rule: identify any number of properties for replacement as long as their total fair market value does not exceed 200% of the relinquished property’s fair market value.
  • The 95% rule: identify any number of properties up to and over 200% of the relinquished property’s value, but only if the exchanger acquires at least 95% of the total identified properties’ value.

Reverse 1031 Exchange: Pros and Cons

Reverse 1031 exchanges may help or hurt your real estate investment strategy. Keep these factors in mind before you start planning.

Advantages of a Reverse 1031 Exchange

The main appeal of a reverse 1031 exchange is the safe harbor that the IRS created with Revenue Procedure 2000-37. It requires the exchanger to park the replacement property with the EAT. Because of this, they are the legal owner, which opens up a list of tax benefits, also known as safe harbor arrangements.

Additionally, following the required guidelines (i.e., hiring a qualified intermediary, purchasing a like-kind property, etc.) makes the investor eligible for tax deferral. This applies to the sales income made from the relinquished property.

However, there are other benefits to this strategy worth considering. For example, the real estate market can be volatile and subject to rapid changes. A reverse 1031 allows you to lock in a replacement property at a time and price that suits you. It also gives you more control over your own closing price when you list the relinquished property after purchasing the replacement.

Challenges of a Reverse 1031 Exchange

Man holding the digital image of a house in his handReverse 1031 exchanges are more complex than forward 1031 exchanges and thus require more careful planning. For example, one of the most difficult challenges comes with financing. Securing a loan in a tight credit market can be difficult. You might not have access to cash to help you make the exchange quickly, and working with a lender creates restraints. And if you don’t sell within the 180-day deadline, then both assets are owned.

Missing the 180-day deadline also costs you any favorable tax treatment. You’ll have to pay capital gain taxes.

It can be more costly than a deferred exchange, too. Your state may require a transfer tax when conveying the property title to and from the EAT as well. Some states view the EAT’s position as an agent of the exchanger, in which case they do not apply the tax. However, each location is different. Multiple closings also contribute to higher costs as well as service fees.

The Takeaway

Reverse 1031 exchanges are a valuable tool to have in a real estate investor’s back pocket. They allow you to purchase your replacement property before selling the one you currently hold. But they’re a complex strategy, which can incur additional expenses if you’re not careful. Speaking with a tax advisor and knowledgeable qualified intermediary will help you navigate this process. They can guide you through the rules applicable to you as a taxpayer.

Tips for Real Estate Investing

  • Real estate is a valuable way to diversify and strengthen your portfolio. However, it also comes with a range of risks. Talking to a financial advisor before you start planning will help you mitigate potential losses. Finding the right one is easy with SmartAsset’s free matching tool. It matches you with local professionals in only minutes. If you’re ready to revise your investment strategy, get started now.
  • If you’re interested in broadening your investment horizons, you may also need to revisit your asset allocation. Finding the right balance can help you ensure your strategy matches your risk tolerance. Check out our asset allocation calculator to review your current portfolio.

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