Some people view purchasing their first property as a goal in and of itself. But, for other people, signing the papers to purchase their first property is only the start of assembling a thriving, diverse real estate portfolio.
The 1031 exchange is one of the finest instruments for transforming a single property into a real estate empire, but the procedure may be challenging. If the regulations are broken, an investor may be exposed to significant tax liabilities, endangering their earnings and real estate holdings.
Choosing the ideal property for your initial investment before turning that first house into a seven-figure empire is vital. Working with a skilled local agent who is familiar with the market and can negotiate the best price for you is the only guaranteed way to do that.
Moreover, if you are ready to do a 1031 exchange, it’s apparent you might have several questions. This blog is here to answer all that.
Read on to explore the top questions many exchangers have and their respective answers.
What is a 1031 Exchange?
Simply put, a 1031 exchange is a provision of the U.S. tax code that enables you to invest the profits of the sale of real estate while avoiding paying capital gains taxes on that income.
Why is this a good opportunity now? Due to the market’s consistently increasing tendency, real estate is sometimes regarded as the safest investment. The profitability of an asset is determined by supply and demand, and the supply of real estate, particularly in crowded metropolitan markets, is strictly constrained.
The significant risks to your long-term returns on a real estate investment are taxes and unexpected, catastrophic market downturns, which are uncommon occurrences that only occur sporadically and are always followed by recoveries. Real estate capital gains taxes, which may be as high as 20%, can significantly reduce your profits.
For instance, you can owe the government up to $200,000 if you sell an investment property for $1 million, which is typical or even below average in many of the most expensive metropolitan areas. Of course, you’d like to avoid this if possible. The 1031 exchange can help.
When you sell an investment property, you can reinvest the earnings into another similar property or even several similar properties, as long as you do so within the IRS-mandated timeline and abide by a few straightforward guidelines. This is how a 1031 exchange works.
What are the 1031 exchange rules?
First, you are limited in the time you have to reinvest the money from the original sale. You have 180 days starting from the day you close on the sale of the relinquished property to close on the sale of the other reinvestment properties. The tax advantages of a 1031 exchange are lost if you don’t complete the transaction within that six-month window.
Second, the kind of assets you can reinvest in are subject to very severe limitations. The “like-kind” rule is another name for this principle. According to the IRS, the property you reinvest in must be similar to the one you recently sold.
However, you can still exchange from one property type to another. Meaning, if you sell a multi-family apartment, you can 1031 exchange into assisted living housing, student housing or even oil and gas fields.
Finally, the value of your following property must match or exceed that of the first property. You can reinvest in several properties as long as their cumulative worth is equal to or more than the initial property; however, there are certain exceptions to this rule, which we’ll cover below. You aren’t limited to a one-for-one exchange.
There are more limitations. Your principal residence disqualifies the property you are selling from eligibility. Fix-and-flip homes cannot be used in a 1031 exchange but must be long-term rentals. The 1031 exchange is intended for long-term, strategic investors.
The limitations mentioned above provide an overview of the 1031 exchange, but additional, more complex constraints mainly concern the number and value of 1031-eligible properties.
The three most significant are the property rules, the 200% rule, and the 95% rule.
What is the three-property rule?
You are permitted to target up to three properties for reinvestment under the guidelines since it might be challenging to identify the ideal property for a one-to-one exchange during the 180-day period of eligibility.
You have 45 days to select up to three properties you may purchase using the profits of your sale. You don’t have to close on all three; you only need to close on one or more. Nevertheless, whether you buy one or all three, the value of your reinvestment must still be greater than or equal to the value of the property you just sold.
The 45-day identification period is strictly enforced; regardless of whether the 45th day comes on a holiday or weekend, you must give the actual addresses of your three properties to the 1031 exchange by the conclusion of that day. The three-property rule does, however, include a few intriguing quirks, just like many other 1031 exchange regulations.
What is the 200% rule?
You may choose to target more than three properties, provided that the combined value of the new properties you decide to target does not exceed 200% of the value of the property you just sold. Hence, if you sell a $1 million property, you can target up to three other properties if their combined value does not reach $2 million.
The 95% rule, however, is a very significant exception to the 200% rule.
What is the 95% rule?
The 95% rule, which stipulates that you must close on at least 95% of the total value of the targeted properties within the 180-day exchange window, kicks in if you apply the 200% rule to go over the three-property limit. If you don’t, you lose the 1031 exchange’s tax benefits and will be responsible for paying capital gains tax.
Because the former always causes the latter, the 200% and 95% rules should be viewed as variations of the same rule.
Working with a knowledgeable and professional real estate agent is the best approach to managing 1031 exchanges. Your property search will go more quickly, and your investments will be safer if you work with a top agent who can tell which way the wind is blowing.
Can you do a 1031 exchange on the primary residence?
Because a primary residence is not a business property, the IRS often disallows a 1031 exchange involving it. Nonetheless, there are several circumstances in which a 1031 exchange on a principal residence may be carried out, according to Section 121 of the Internal Tax Code (IRC). This is how it goes.
According to Section 121 of the IRC, a primary residence held for at least five years and occupied for two of those five years may be excluded from capital gains tax through a 1031 exchange. You must demonstrate to the IRS that you rented out the property at market rate and that you actively proved you resided somewhere else while utilizing the property for business purposes to qualify for the exchange.
What happens when you sell a replacement property?
A 1031 exchange simply delays your capital gains tax obligation; it does not entirely eliminate it. So, you are responsible for paying the capital gains tax you carried over from the original property when you sell a 1031 exchange property.
You should use caution while making your following 1031 exchange investments. The actual value of the 1031 exchange lies in the fact that you may sell and reinvest utilizing a 1031 exchange numerous times. If you reinvest in a strong market, your earnings from your subsequent investments will ultimately surpass the capital gains you are carrying from your first property.
Nevertheless, if your subsequent investments don’t grow in value, you have to pay capital gains taxes on the sale(s) of the property and sell it at a loss.
What are the benefits of doing a 1031 exchange?
By using a 1031 exchange, you may postpone paying your capital gains tax and reinvest the profits from selling one property into another or even many properties. Delaying your tax burden until after your assets have increased enormously enables you to invest your profits in additional properties ultimately.
How do I file a 1031 exchange?
A competent intermediary who will carry out the actual financial transaction as directed by you and your agent and ensure that all legal criteria are met is required if you want to submit a 1031 exchange. They’ll arrange the transfer of properties between you and the other parties and keep the transferred monies in escrow throughout the transitional time. This firm is also known as an exchange facilitation company. By doing this, you will guarantee that you adhere to the precise definition of a real transfer and never get the sale proceeds in your hands.
How long do I need to hold a property before doing a 1031 exchange?
The duration of ownership of a 1031 exchange property is not legally mandated to be eligible for tax benefits. But if you “flip” the property soon after buying it, the IRS could think you didn’t plan to retain it as an investment, and they might declare the transaction illegal.
Most experts agree that to demonstrate your serious intention to make long-term investments, you should hold onto a 1031 exchange property for at least a year before selling. The IRS has repeatedly suggested a one-year requirement, suggesting they believe this to be a realistic barrier even though there isn’t a time requirement under the tax rules.
The 1031 exchange may be one of the most effective strategies to expand your real estate portfolio, provided you adhere to all the laws and guidelines. A single, initial property may be transformed into a profitable real estate portfolio considerably faster with shrewd investment and the 1031 exchange than if you only invested in a property sequence and paid capital gains on each sale. Making the appropriate investments is one of the main components of this equation, along with having a thorough grasp of the requirements of the 1031 exchange.