We know that a lot of real estate specific terms and rules can be confusing to someone outside of the industry. The fact that rules can adapt and change from state to state and even transaction to transaction (because of all the moving parts) doesn’t make it easier. One of the most misunderstood real estate concepts is that of a 1031 Exchange. Simply put, a 1031 Exchange is a way to defer taxes paid on capital gains. Capital gains, of course, is your profit. Whether you’re a real estate investor or just a “normal buyer”, a 1031 Exchange may be of interest to you.
In order to defer the capital gains taxes when selling a property, in a 1031 Exchange, buyers “swap” to another property. When the original property is sold and another property is bought — there are limited or no taxes paid under the 1031 Exchange. Keep in mind that deferred taxes does not mean permanently exempt from taxes. If one were to sell the new property and not do another 1031 exchange, their taxes will be due. There are, of course, stipulations to this.
For starters, the exchange in question must be a “like-kind” exchange as defined by the IRS. This is broader though than many think. Almost all real estate to real estate exchanges qualify — you can swap land for a building but you can’t swap a house for a car, etc. Residential properties also do not qualify for the 1031 exchange — only investment properties. So rentals and commercial buildings and other business and investment properties count but not primary residences.
Next comes deadlines. Specific and stringent deadlines are no stranger in real estate and a 1031 is no exception. If a deadline is missed even by a minute — capital gains taxes are due and a 1031 exchange is impossible.
45 Day and 180 Day Rules
The first deadline buyers need to be aware of is the 45 day deadline. Once the original property is sold, the sellers turned buyers now have 45 calendar days to find a new property to purchase. Once a property is sold, the middleman or the intermediary (almost all cases require an intermediary by law to conduct a 1031 exchange) will be the one to receive the money — not the owners.
Within 45 calendar days from the day a property was sold, a designated replacement property must be submitted in writing to an intermediary. Three properties can be identified in writing or even several properties can be listed as long as they don’t exceed 200% of the value of the original property. Each property with descriptions but they must be submitted in writing within 45 days to continue on with a 1031 exchange.
Including the 45 days it takes to select a property or properties — from the date of sale of the original home, an owner also has 180 days (135 after the 45) to close escrow on a new property. Transactions must be closed before the 180 days in order for capital gains tax to be deferred and for a 1031 exchange to go through successfully. This is a decent amount of time if buyers and sellers are willing to act fast — just remember that some escrows can be 60 to 90 days.
As with anything, especially in real estate, there are more specifics on 1031 exchanges that may vary on a case by case basis but if you’re interested in a 1031 exchange or just want to be more knowledgeable — this is a great place to start. A 1031 Exchange is a useful financial tool for those looking to own multiple investment properties or upgrade ones they already have.