Selling your property could have huge tax implications. However, reinvesting the sale proceeds into another property through a 1031 like-kind exchange can offset the tax liability associated with your sale gains. Here's what you need to know.
A 1031 like-kind exchange is a tax and reinvestment strategy that allows you to reinvest the proceeds from the sale of real estate into new real estate, without incurring capital gain taxes upon sale.
The primary reason to execute a 1031 exchange is to redeploy capital into investments that are greater in scale, more diverse, or more aligned with your current investment strategy. And because taxes are deferred, more of the sale proceeds can be immediately directed toward your new investment.
Many investors can benefit from deferring the tax liability associated with the sale of real estate through a 1031 exchange. However, there are strict regulations and guidelines to be aware of that dictate what constitutes a valid exchange. Five important regulations to be mindful of are discussed below.
Five 1031 exchange regulations you need to follow
1. Properties must be “like kind” to qualify.
Most real estate held for use in the trade of business or for investment will qualify for an exchange. The regulations state that the exchange must be between qualifying properties of like kind, but it doesn’t matter if the type of asset you sell is the same as what you buy. For example, you will not be limited to purchasing a multifamily building if you sold a multifamily building.
2. You must meet strict deadlines.
A1031 exchange timeline is strict. In order for the 1031 exchange to be valid, up to three replacement property options can be identified as part of the exchange no more than 45 days from the time your original property is relinquished. In most cases, you must close on the purchase of one of those new properties within a strict 180-day window.
The COVID-19 pandemic has spurred the IRS to extend deadlines for 1031 exchange transactions with deadlines between April 1 and July 15, 2020. Read more here.
3. Sale and purchase prices must be equivalent.
The total net sales price of the property you’re acquiring must be equal to or greater than the total net sales price of the property you’re relinquishing. In addition, you must use all of the equity from the transaction to acquire the property targeted in the 1031 exchange. If your replacement property’s purchase price is less than your relinquished property, you will be taxed on the you will be taxed on the portion not reinvested.
4. Equity in the properties must be equivalent.
Another fundamental rule requires that the net equity in your replacement property must be equal or greater than the net equity in the property you sold. If not, you will be required to pay taxes on the amount of decrease.
5. You must use a qualified intermediary.
Simply selling the building or property and using the proceeds to purchase another disqualifies the exchange. The sale must also go through a qualified intermediary — an independent organization that will handle the funds from the original sale through the exchange process and then deliver the money to the closing agent. The intermediary will also be responsible for filling out all of the appropriate tax forms and exchange agreements related to the process.
Every investor’s situation is different, and each situation can trigger different nuances within these regulations.
Exchanges in the current real estate market
Investors face several challenges when attempting a 1031 exchange to defer taxes on gains incurred on the sale of a property, including:
- Finding quality investments in an increasingly uncertain and competitive market
- Choosing the right 1031 intermediary
- Sellers leveraging tight deadlines to their advantage
- Sellers who might not take your offer seriously because of the 1031 process
Planning with a real estate investment consultant and a tax advisor is essential to successfully executing a 1031 like-kind exchange. An unbiased real estate professional can lay out all of your options to help determine if a 1031 like-kind exchange is a feasible option. Our experts can also advise if more unique strategies, like a “reverse 1031 exchange” or Opportunity Zone investments, are appropriate for you.
Investors should note that the COVID-19 pandemic has spurred the IRS to extend deadlines for 1031 exchange transactions with deadlines between April 1 and July 15, 2020. Read more here to learn how that affects exchanges currently taking place.
If you’re interested in learning how to do a 1031 exchange, contact our team today. Plante Moran REIA can help navigate these challenges and proactively identify options before you sell to increase the likely success of your 1031 exchange. Our tax, real estate, and investment expertise helps you make an informed decision about the sale of your property.
This article was originally published in 2015, and has been updated several times to reflect current trends.
Plante Moran Real Estate Investment Advisors published this article to convey general information about our services and market conditions, not for the purpose of providing investment advice. Strategies mentioned herein may not be appropriate for you. Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain. You should consult an investment professional regarding your own situation.