What is a 1031 Exchange in Real Estate?
One of the most significant hurdles for real estate investors can be the hefty tax burden that comes with selling an investment property. This is especially true if you are just starting out and need all the free capital you can get. A 1031 exchange can help certain investors bypass the tax on capital gains after a sale. Let’s take a closer look at what a 1031 exchange in real estate looks like and when you should consider one.
Basics of a 1031 Transaction
A 1031 exchange, also known as a like-kind exchange or a tax-deferred exchange, is a provision in the U.S. tax code that allows real estate investors to defer paying capital gains taxes when they sell an investment property and reinvest the proceeds in another similar property. The name “1031 exchange” comes from Section 1031 of the Internal Revenue Code.
How to Qualify for a 1031 Exchange
The eligibility requirements for a 1031 exchange are relatively straight forward:
First, you must use the capital gains from your old property to purchase a “like-kind” investment property. This does not, necessarily, mean a tit-for-tat exchange. For example, you do not need to exchange one apartment building for another. You can trade up from a rental unit to an office building, land, or virtually any other real property-so long as it is an investment property.
Equal or Greater Value
The new property must be of equal or greater value to the one you wish to trade.
Must Reinvest All Sale Proceeds
All capital gains from the sale of the prior investment property must be reinvested into the new one, either as a down payment or for upgrades to the new property (see below).
Same Title Holder and Tax Payer
The person deferring taxes on the sale of a property must also be the title holder of said property.
Types of Property Exchanges Using Section 1031 Transaction
There are four categories of real estate investment that may qualify for a 1031 tax deferral:
Ideally, you would be able to identify a new, like-kind investment opportunity and acquire it at the same time as you sell your old property. This is what is known as a simultaneous exchange. The sale of your property and the purchase of the new one must close on the same day in order to qualify as simultaneous. Any delays could make the sale ineligible for the 1031 tax deferral.
It is more common for there to be a lag in time between when you sell your existing property and close on a new one. This is known as a delayed exchange, and it allows for the sale of an existing property prior to purchasing a new one. In a delayed 1031 exchange, proceeds of the sale are held in a binding trust by a third party called a Qualified Intermediary. The investor then has 45 days to identify a new property, and 180 days to close on it.
A reverse exchange entails buying a new investment property before you sell your old one. In this case, you will have 45 days to decide which of your current properties you want to trade for the one you have just bought. You will have a further 135 days to complete the sale.
The drawback of reverse exchanges is that it can be difficult to secure a loan, since they are inherently riskier. After all, you will not have the equity from your prior investment to back the new purchase. For this reason, reverse exchanges are often cash-only. Many banks are unwilling to loan on a reverse exchange, since there is no guarantee you will sell your old property within the required 180 day time frame.
Also known as construction exchanges, improvement exchanges allow you to use the exchange equity to make upgrades or renovations to the new property before actually closing on it. Like delayed exchanges, the property will be held in trust by a Qualified Intermediary for up to 180 days, during which time you can use the proceeds from the sale of your old property to make improvements on the new one.
The caveat to an improvement exchange is that the property still needs to be “like-kind,” which means it cannot change significantly. After improvements, it must be appraised at the same or higher value than before.
Benefits of a 1031 Exchange for Investors
The ability to defer paying taxes on capital gains can be invaluable to investors for several reasons:
Long-term Wealth Building
Real estate investors can continue to grow their wealth by repeatedly utilizing 1031 exchanges. Over time, this strategy can result in substantial gains without the burden of immediate taxation.
In theory, you can defer capital gains taxes indefinitely using the 1031 exchange method. So long as you continue to trade up properties and meet the 45 and 180 day deadlines, there is no limit to the number of exchanges you can request. This allows investors to transform short-term gains into long term ones, which are often taxed at a lower rate (even zero percent, in some cases).
A 1031 exchange enables you to diversify your real estate portfolio without incurring immediate tax consequences. You can transition from one property to another or exchange multiple properties for a larger one, all while deferring taxes.
Increased Buying Power
By deferring capital gains taxes, you have more capital available for your next investment. This increased buying power can lead to acquiring higher-value properties or multiple investments simultaneously.
Capital for Real Estate in Colorado
If you are looking to expand your investment portfolio in the state of Colorado, contact the professionals at Pinetree Financial. We have been in business for more than thirty years, helping Colorado investors achieve their project goals. Call or go online today to get started.