1031 Exchange: What it is and how it works

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Michaela Phillips, Guaranteed Rate, Inc.

Michaela Phillips, Guaranteed Rate, Inc.

BOULDER – When you sell an asset of any kind, the profit that you earn is referred to as capital gains. In most cases, you are expected to pay a capital gains tax on this amount. There is, however, a section of the United States tax code (Section 1031, as you may have guessed) that offers shelter to investors. A 1031 exchange, in the simplest terms, is a matter of replacing one investment with another. It is named after the corresponding section of the United States tax code and is sometimes also referred to as a “like-kind exchange”.

For many property owners, the details of this type of transaction are extremely bewildering. Perhaps the biggest point of confusion is that in many ways, this is more of a rollover than an exchange. You can think of it as taking the profit from one investment and using that to invest in something else. In the eyes of the IRS, this is not a matter of cashing out on your earnings; it is simply a way of letting your capital grow further. If you’re interested in seeking tax shelter under Section 1031, here are some of the factors that affect your eligibility:

Type of Property

The term “like-kind” was mentioned previously. To be clear, that is a way of saying that the two assets involved in a 1031 exchange are the same type of property. For example, you’re not going to sell a rental property, take that capital and reinvest in bonds, and expect to quality for 1031 exchange treatment. However, if you sell a duplex rental and roll that profit into the purchase of a larger apartment complex, you will qualify.

Your Intent

The way you plan to use a property carries significant weight in determining whether or not your transaction qualifies as a 1031 exchange. A property that is used as your primary residence is not permitted, but the same home would qualify if you used it as a rental, instead. Another factor that falls into this same category is that the property must be intended for long-term holding. The purpose of Section 1031 is to allow your long-term investments to grow. For this reason, properties that are purchased, renovated, and relisted do not qualify. The money that is made from this type of “flipped” real estate is considered to be resale profit, not return on investment.

Time and Cost

Within 45 days of selling your previous property, you must provide a list of potential new investments. This is known as the 45-day identification period. This time allotment begins the day after closing, and it includes weekends and holidays. Extensions are not granted under any circumstances.

On your list of identified properties, you may include up to three replacement properties without regard to value. They can be worth any amount that you can feasibly afford. If you wish to replace your initial asset with more than 3 replacements, the IRS requires that the cumulative value of all properties combined must not exceed 200% of your previous property’s value. This stipulation is appropriately known as “The 200% Rule”. Moreover, the replacement(s) must have a value that is greater than or equal to the previous asset.

It is required that all cash profits be reinvested. You are not permitted to use this money in any way between one investment and the next. That period lasts no more than 180 days, which is another time limit that is imposed on investors in a 1031 exchange. If you are not able to close your transaction on at least one of your replacement properties within 180 days of selling your previous property, you will lose eligibility for the 1031 shelter.

This has the potential to cause some very expensive issues for investors. The timing needs to be just right. If your second investment property is part of an infill development (which means that your closing will depend upon completion of construction), be sure that your developers are going to be running according to schedule. The IRS is not going to cut you a break because your property development was delayed. They care only about the actual date of closing, without exception.

Involved Parties

The titles for both properties must be a “mirror image” of one another. That is, the same taxpayer that is listed on the first title must also be listed on the next. Also, because of the aforementioned rule that prohibits you from using the funds between investments, you will be required to seek the services of a qualified third party, known as an intermediary. The intermediary must have no business or family ties to you, and is held accountable for all funds that are being rolled over. He or she is also responsible for ensuring that all of the necessary IRS paperwork is completed at all closings involved in the exchange.

Finally, if interest is earned on the funds while they are being held by your intermediary during the 180-day period, you are entitled to keep the money earned and record it as ordinary income.

All of this may seem like a lot to process, but there are countless other details that you’ll need to understand if you plan to do a 1031 exchange. Your best option is to speak with someone who is familiar and comfortable with all of the intricacies involved. If you are interested in learning more about how a 1031 exchange can help you grow your net worth, contact me by phone at 303.579.5517 or via e-mail at michaela@michaelaphillips.com. I would be thrilled for the opportunity to help you expand your investment portfolio.

Michaela Phillips is the Vice President of Mortgage Lending at Guaranteed Rate, Inc., the 8th largest retail mortgage company in the country. Since entering the mortgage industry in 1994, she’s consistently been a top producer. Being a VP at Guaranteed Rate offers many advantages to her and her clients including unparalleled customer service, efficiency, and most importantly competitive rates. NMLS: 312874

By Michaela Phillips, Guaranteed Rate, Inc.

 

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