1031 Exchange Rules – What You Need to Know
Whether you’re a brand-new real estate investor or you’ve been building your personal net-worth through real estate investing for years, you already know that one of the most important aspects of real estate investing is being sure that you’re operating within the framework of the law. There are tax ramifications to all sorts of real estate transactions, so it’s important that you understand and obey the regulations for the moves you make in your real estate investment business.
What is a 1031 Exchange?
According to the IRS Tax Code, a 1031 exchange is a transaction in which you exchange real property that has been used for business or held as an investment for another business or another investment property that is considered the same type. Some investors refer to 1031 as “like-kind” exchanges because the properties being exchanged must be of the same type. Congress passed the law that made these exchanges possible all the way back in 1921 as a way to encourage active reinvestment. However, Congress also passed a number of laws that regulate the way that 1031 exchanges work, and it’s important that you follow all of them.
What Types of Properties Are Eligible?
You can’t just trade a property that you’ve invested in for another property and claim it as a 1031 exchange. There are requirements that must be met in order for you to file a legal 1031 exchange. It is worth noting that the IRS considers investment properties to be of like kind no matter how the subject properties have been improved. That means that if you have spent thousands improving an apartment complex and exchange it for one that hasn’t been rehabbed, it is still considered a like kind property. Investment properties can be exchanged for any other investment properties. For instance, that apartment complex that you rehabbed in the hypothetical situation described above can be traded for vacant land, another apartment complex, an office complex or a shopping center. In virtually every case, this trade will still meet the requirements for a 1031 exchange.
The Different Types of 1031 Exchanges
Most real estate investors who utilize 1031 use at least one of the five main types of 1031 exchanges. The five types of 1031 real estate exchanges are as follows:
• Delayed/Simultaneous Exchanges: The replacement property is purchased at the exact same time that the original property is sold.
• Delayed Reverse Exchange: The replacement property is purchased before the current property has been relinquished to its new owner.
• Delayed Exchange: The current property is sold or relinquished, and a replacement property is purchased during the allotted window of time.
• Delayed Built-to-Suit Exchange: The current property is relinquished, and it replaced by a property that is built to suit the current needs of the investor.
• Delayed/Simultaneous Built-to-Suit Exchange: The property that has been built to suit the investor is purchased before the current property is sold.
Value Rules for 1031 Exchanges
You cannot exchange an investment property that is worth $150,000 for a property that is valued at $50,000 and turn it in as a like-kind exchange. If that were possible, investors would use the ability to trade down as a way to get out of paying taxes on their more valuable properties. Instead, the IRS Tax Code mandates that like-kind exchanges must be for a property that is of the same or greater value than the property being relinquished.
Time Requirements for 1031 Exchanges
There are also timeframe requirements that must be met before you can use a 1031 exchange as a tax deference. First of all, you must provide written proof that identifies the replacement property within 45 days of relinquishing your current property. Additionally, the purchase of that replacement property has to be finalized within 180 days of relinquishing your current property. This ensures that investors don’t avoid claiming capital gains on their taxes with no plans to reinvest the funds.
As is always the case when dealing with real estate investments and taxes, you should work with a tax professional or a real estate attorney who can help you ensure that you are operating according to federal laws. 1031 exchanges provide a great opportunity for you to build your real estate investment business through the use of these exchanges and the tax benefits that come with them.