When you sell an investment property at a profit, you typically have to pay taxes of up to 20-35% (depending on what state you live in) on that profit.
But with the 1031 exchange, you can take all of those taxes you would have paid, and invest them in another property…amazing!
So how does it work? Here’s everything you need to know about the 1031 tax exchange, from an easy to understand definition, to the timeline, to how you can actually use it.
What is the 1031 Exchange?
It allows you to roll your profits from one investment property into the purchase of another like-kind property. It’s also described as a “like-kind exchange.”
If you follow the rules, you’ll save boo koo bucks because you won’t have to pay any taxes on the profit (for now). It’s important to note that your taxes are deferred, (similar to the way they are in many retirement accounts), not completely wiped out.
A 1031 exchange is a bit of complicated process, even for professionals. So you’ll need to work with a firm that handles the process for you. But honestly by doing that, the process becomes pretty darn easy!
What is a “Like-Kind Exchange”?
One big part of the 1031 exchange is you need to “exchange” an existing property for a “like” property. In its original conception, the 1031 exchange applied when one property was directly swapped for another.
For example, you can use the exchange when selling one rental property and buying another of equal or greater value. That said, there are four different kinds of like property exchange options.
Keep in mind that each has to be completed on a certain timeline and also meet specific financial criteria. Here are the four types.
The first like property exchange is a simultaneous exchange. This occurs when you exchange one property directly for another. The relinquished property and the new property must close on the same day.
The timing has to be very exact for you to use this 1031 exchange. Because of this, it most often happens with a direct deed swap. But it’s also possible to do a three-party exchange with a compliant third party or to work through an intermediary.
Despite all the rules, in the end the exchange is basically a set of documents. Below are samples of the first pages of the sale docs (relinquished property) and the purchase docs (replacement property), from one of our exchanges. This gives you an idea of what all is involved.
The second type of like property is called a delayed exchange. Since this type of exchange gives you more time and has more flexibility, it’s the most common type of 1031 exchange people use.
Even still, you do have a time constraint. You have 45 days to find a new property to invest in, and 180 to close the deal before you’ll owe taxes on the profit of your sale.
The new property (or combination of new properties) must be of equal or greater vale than the sold property. So, for example, you can sell one more expensive property and buy four cheaper properties.
With a reverse exchange, you buy your new property before relinquishing your previous investment property. However, you need cash for the whole deal.
You have 45 days to decide which property you’re going to sell, and you have 135 days to sell it.
It’s critical to note however, that the cost to do a reverse exchange is literally about 8x higher due to the far greater deal of paperwork needed. I had a good opportunity to do it once, but the cost made it not worth doing the deal.
Construction or Improvement Exchange
The last option is the construction or improvement exchange. With this type of 1099 exchange, you use the profits from your last investment property to make improvements to a new one.
Similar to the other types of 1031 exchanges, you still have time requirements you need to follow. You have 180 days to spend the exchange equity on down payments or completed payments for improvements on the new property.
You have 45 days to exchange “substantially the same property” identified by the taxpayer.
And finally, the replacement property must be of equal or greater value when deeded back to the taxpayer.
What is the 1031 Exchange Timeline?
As you can see, the type of property you invest in will affect the timeline you have to abide by. But no matter what type of 1031 exchange you’re using, circle day 45 and day 180 as ones to remember, because that’s when your deadlines are due.
Typically, the 45-day mark is when you need to designate a replacement property. If you don’t have a replacement property lined up by day 45, you’ll lose your 1031 exchange, and have to pay capital gains taxes on your profit.
The 180-day mark is when you need to close the deal. Again, if you miss this mark, you’ll lose the 1031 exchange and owe taxes.
What are the 1031 Exchange Rules?
In addition to carefully following a timeline, you also need to carefully follow rules. Generally, 1031 exchange rules apply no matter what state you’re in. But it’s always best to have an expert on your side. Screwing up the process will cost you thousands of dollars.
So what rules do you have to follow? There are seven of them.
- Must be a like-kind property
- Investment or business purposes only
- Of greater or equal value
- Must not receive “boot”
- Same taxpayer (maintain same ownership)
- 45-day identification window
- 180-day purchase window
1031 exchanges apply only to investment or business properties. You cannot apply them to a residential property.
For a 1031 exchange to apply, you have to use it when exchanging property for one of equal or greater value. Otherwise, there would be little point, since you wouldn’t owe taxes on it.
The “boot” is when your investment property creates revenue during the 1031 exchange, and it will be taxed as capital gains. Therefore, for your 1031 exchange to completely tax-deferred, you can’t receive boot during that time.
The same taxpayer rule simply means that the same taxpayer has to have their name on the old deed, and on the new one. If there are multiple owners, all of the owners must be on the new deed as well.
Who Can I Hire Someone to Help Me and How Much Does it Cost?
The firm I use
Personally I have completed three 1031 exchanges. I used the same firm every time and I recommend them highly. The company is API Exchange. They are based in CA, but can do exchanges all over the US.
The cost to do a 1031 is pretty reasonable, especially compared to what you would pay in taxes!
API charges about $1000 for a standard exchange. That would be exchanging one property for another. As you add properties onto the deal, you will pay about $250 per property (whether it be on the selling side or buying side of the exchange).
These funds will be paid directly to the exchange firm as part of the closing. Since the firm is holding your proceeds from the sale, they actually just deduct their fees from what they send to escrow.
The Flow of Funds
Speaking of money, let me explain how the flow of the proceeds goes down.
When you sell your property, all of the proceeds from your sale go to your 1031 firm directly from the escrow/tile company handling your transaction. The exchange firm holds all the funds until it’s time to send money into your purchase escrow.
Once you identify a house and open a purchase escrow, you will alert them that your are doing an exchange. You’re more than welcome to use your 1031 funds for the earnest money on the purchase, if you can manage it time-wise.
If your purchase is such that you have to get your earnest money in quickly, and you don’t want to wait to schedule moving it over from the exchange, that’s ok. You can simply contribute the earnest money out of your pocket, and just send all the exchange money in when the purchase closes.
Again, you will introduce your escrow company to your 1031 exchange folks, and they will facilitate a wire directly when your closing funds are due. Any remaining funds needed, beyond what is in the exchange account, you will wire in yourself.
The 1031 Exchange is the Secret Tool You Can’t Afford Not to Use
When you understand how to use a 1031 exchange, it will save you tens of thousands of dollars. You can utilize this valuable tool anytime you sell an investment property to roll over the sale into a new investment property, without paying taxes.
To properly use this tool, it’s vital to understand the rules and timeline. But once you learn the basics, it’s easy to implement.
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