If you’ve heard of a 1031 exchange, you probably know it relates to real estate. But, it’s easy to get confused about what it is and how it works. That’s okay. A real estate 1031 exchange is a way to simply swap one property for another without paying taxes on the deal. Now, it’s not a magic bullet. Yes, you will pay taxes, just not immediately. But, it’s a great way to switch up properties with less hassle and stress to gain some key advantages.
What is a 1031 Exchange?
Simply put, a 1031 exchange is a section in the tax code (just like a 401k). It allows an owner to exchange one property for another. Essentially, you can swap one investment for another in the eyes of the IRS. And, there’s no limit on how many times you can use a 1031 exchange. Basically, you’re rolling a gain or profit from one piece of property to another (then another and still another) so it grows in a tax deferred status.
Tax nerds may be able to spout off Internal Revenue Code Sections, but most people never get beyond 401(k). (That’s right, your workplace retirement savings plan is named after a section of the tax code.) Still, ‘Section 1031’ is slowly making its way into daily conversation, bandied about by realtors, title companies, investors and soccer moms. Some people even insist on making it into a verb, a la FedEx, as in: ‘Let’s 1031 that building for another.’ —Forbes.com
Eventually, when you reach a certain point, you’ll only pay taxes when you actually and finally sell a property. Even at that, you’ll just owe for capital gains and not for your income tax bracket. So, you’ll pay the capital gains tax of 15 percent. (That’s certainly better than the alternative progressive income tax bracket rates which are substantially higher.)
Basic 1031 Exchange Rules
Of course, there are restrictions when it comes to doing a 1031 exchange. The IRS doesn’t let investors treat the tax advantage like a free-for-all. However, there are some pretty wide boundaries. And, the basic 1031 exchange rules are simple to understand:
- The current property must be eligible. Not every real estate property is eligible for a 1031 exchange. For instance, personal residences, land under development for resale, and fixer-uppers and flips are typically ineligible. But, most investment properties, like multifamily housing, does qualify.
- The replacement property must be titled the same. How the current property is titled is how the exchange property must be titled. So the titling must match from one property to another to qualify.
- The replacement property must be like the other one. This is a simple rule — the replacement property must also be like the relinquished property. However, this language is confusing because it doesn’t mean what you think it means. For instance, you can replace unimproved land for a strip mall. Or, a ranch for an apartment building.
Lastly, if you receive any “boot” or a bonus, that is likely taxable and so you shouldn’t trade down. If you’d like to learn more about commercial real estate investment benefits and more about the process, please contact me.