Do you have several estates and would like to know how to reduce your taxes? Or, are you trying to sell one lot in replacement for several estates? Then this article is the right one for you.
You see in the real estate business, growth is inevitable. Once you own your first deal, you are drawn to invest in more assets to increase your portfolio.
What is 1031 Exchange? 1031 Exchange was named after the U.S. Internal Revenue Code Section 1031. It is the swapping of one investment lot for another and allowing your capital gain tax to be deferred.
A common scenario for a 1031 Exchange is selling a valuable lot in replacement for multiple rental estates. This usually occurs in states like California, New York, and Hawaii where there is high appreciation.
Here is a scenario for you to better understand how the process works:
An investor who owns an estate in New York for the past 10 years. While the cash flow is still positive, the land has appreciated nearly 6X the purchased price. The owner is looking forward to selling his land prior to his retirement age. To avoid tax, the investor will do a 1031 Exchange and purchase multiple lands in a cheaper area.
What are the 1031 exchange rules?
When doing a 1031 exchange, there are rules you need to follow:
- There’s a 45 day identification period and a 180-day exchange completion period.
- The 45-day identification and 180-day exchange completion periods start when the first of several sales close.
- Replacement land should be of equal or greater value than the land you’ll give up.
How to choose a Replacement Property:
After understanding the basic rules, you now have to learn how to choose a replacement land. We’ve already established it should be a like-kind. But, you have to be reminded of some special rules:
- The Three Property Rule: This rule states that you can choose between three lands for you to reinvest in.
- The 200% Rule: If you target more than three to exchange with, there is no need to worry. But, make sure the value does not exceed 200% of the value sold.
- 95% Rule: This is an extension of the 200% rule. It states that within the 180-day deadline, you have to close in on at least 90% of the targeted land combined value. Failure to do so forfeits the advantages of a 1031 exchange, meaning you’ll still have to pay capital gains tax.
The Types of 1031 Exchanges
There are actually many ways to do a 1031 exchange.
- Reverse Exchange: This means that you first acquire the replacement land through an exchange accommodation titleholder, without having performed the 1031 exchange. Namely, buy first, exchange later.
- Delayed Exchange: This method is the most commonly used one. In this procedure, you relinquish your original land, then transfer the sales to buy the replacement.
- Construction/Improvement Exchange: This exchange allows the replacement land to be renovated during the 1031 exchange. However, all the renovations must be finished by the 180 day period.
- Simultaneous exchange: A simultaneous exchange means that the relinquished property and the replacement estate both sell at the same time.
How to start on your 1031 Exchange?
The first step in starting with your 1031 exchange is to call your exchange Facilitator. Before calling, make sure you have all the information at hand such as name, address, phone number, and so on.
Here are 9 major steps to follow when doing your 1031 exchange
- Select the property you want to sell
- Determine who is going to be your QI (Qualified Intermediary)
- Provide a relinquished property addendum to the contract offer
- Ask for the sales contract from the QI
- Identify replacement lands
- Provide a copy of the sales contract to the QI
- Sign the contract of the new property
- Close the replacement property
- File an 8824 IRS Form
1031 Exchange Rule of thumb
The owner has 45 days from the date that the relinquished land closes to identify the property for the exchange. If in the event that there is more than one property relinquished in one exchange, the 45 days is measured from the first closed relinquished property.
The identified lands do not have to be under contract, and the one doing the 1031 exchange does not have to acquire everything he/she identified for the exchange.
There are guidelines on how many lands an owner can identify. In a lot of instances, the one doing the 1031 exchange uses the three property rule.
In the event that the owner would like to identify more than three properties, he/she can avail of the 200% rule. The 200% rule states that the owner can identify any number of replacements as long as the fair market value of the identified land does not exceed 200% of the fair market value of the relinquished land.
When Does Vacation Property Qualify for a 1031 Exchange?
An owner who purchases and sells vacation homes may assume that their vacation house will not qualify for a 1031 exchange. But, in cases where vacation house is used primarily for business use, with minimal personal use, it is probable to defer capital gains tax through a 1031 exchange. To defer capital gains tax through a 1031 exchange, the relinquished and replacement lands must be held by the exchanger for productive use only. It can either be for a trade or business and not for personal use.
The IRS issued the Revenue Procedure 2008-16, which provides a safe harbor for dwelling units to qualify for the 1031 exchange despite the home being utilized for personal use at times.
For a vacation home to qualify for the safe harbor requirements and be part of the 1031 exchange, the owner must hold the relinquished land for at least two years preceding or following the exchange. In each of the two 12-month periods, the owner must rent the property at market value for at least 14 days. However, the owner may use the vacation property for personal purposes up to either 10% of the number of days the property was rented within the 12-month period or 14 days, whichever is greater.
One more important Note:
When exchanging multiple estates, you don’t have to exchange them all at once. In fact, you can make separate exchanges for each property. These methods are called the one-exchange procedure, and the multiple-exchange procedure.
The one-exchange procedure exchanges all the lands you want to give away all at once. This means the exchange, sales, and purchases should all happen within the 180-day timeline. This method is faster and less expensive than multiple exchanges. But, it does not provide much flexibility.
However, the multiple-exchange procedure exchanges the relinquished lands separately from each other. This means that there will be a separate 45-day ID period and 180 day exchange period for each of them. This method of a 1031 exchange is slower and much more expensive. But, this method provides more flexibility and time to the investor than the first one.
Now you see that a 1031 exchange is an advantage to real estate entrepreneurs out there. Although it may seem really simple, it is advised that you should talk to professionals so you reap the full potential of a 1031 exchange. Because, if used correctly, this will certainly help you get one step closer to the empire you’ve been dreaming of.