Taking Advantage of 1031 Tax Deferred Exchanges
Investors who own an appreciated property can defer payment of their capital gains taxes using a 1031 Tax Deferred Exchange (also known as a “Like Kind” exchange. 1031 tax deferred exchanges allow property owners to sell a property and use 100% of the equity and profit from the sale to purchase and invest in a new property (or properties) of their choice.
Why Set Up a 1031 Tax Deferred Exchange
A standard 1031 Reverse Exchanges allows investors to sell their property before acquiring a new asset. 1031 tax deferred exchanges allow investors to keep their money working for them. Although they will one day cash out and pay capital gains taxes, 1031 tax deferred exchanges allow investors to reinvest 100% of their money right away. It’s a useful tactic to keep getting the most out of invested assets rather than reducing the value of a portfolio by paying out taxes sooner than necessary.
Who Can Take Advantage of a 1031 Tax Deferred Exchange?
Many types of people/entities qualify for a 1031 tax deferred exchange, including:
- Individual investors
- Both “C” and “S” Corporations
- Limited Liability Companies
- Partnerships (limited or general)
- Many other tax-paying entities
Qualifying Properties of 1031 Tax Deferred Exchange
The main requirement for a 1031 tax deferred exchange is that the property must be owned for either trade, business or investment purposes. This can include rental and multifamily properties. The key exception is that properties must not have been held for sale (i.e. as inventory for a business). This is known as the Qualified Use Requirement. Some properties either qualify, or only partially qualify for 1031 tax deferred exchanges:
- Vacation, Lake or second homes do not qualify (even if they have been rented for a portion of time).
- Multifamily properties where the owner resides in one of the units is usually split, with proceeds from the rented units funding the exchange.
- Farmland where owners reside on the property. Once again, this usually ends up being split, with the percentage of the property being used for farmland may be exchanged.
- Personal residences where the owner lives and works. As with the other cases, these are usually split, with the percentage being used as an office can be used in an exchange.
If you are unsure if your property falls under the Qualified Use Requirement, you should consult with a financial advisor, tax or real estate attorney of the IRS.
Types of 1031 Exchanges
There are four major types of 1031 exchanges:
- Simultaneous 1031 Exchanges: where investors relinquish old properties and acquires new property on the same day, usually between the same parties. These exchanges are uncommon because it’s rare to find two property owners who are willing to directly exchange properties with one another.
- Delayed 1031 Exchange: investors sell their property first and use the equity/profits to purchase one or more new properties. Investors have 45 days to identify a replacement property and 180 days to complete the exchanges or they could be subject to paying capital gains taxes on the proceeds of the sale of their relinquished property. This is the most common type of 1031 exchange.
- Reverse 1031 Exchange: investors acquire a new property before selling an existing one. Investors normally “park” their relinquished property with an LLC called an exchange accommodation titleholder (EAT) while they purchase a replacement property.
- Construction/Improvement 1031 Exchange: investors exchange their existing property with one that is worth less, then immediately use the leftover funds to pay for improvements and upgrades on the replacement property.
Rules and Limitations of 1031 Tax Deferred Exchanges
There are certain conditions that must be met for a successful and legal 1031 tax deferred exchange:
- The property must meet the Qualified Use Requirement (as described above). It cannot be personal property.
- The properties must be “Like Kind.” This means that they must be of the same nature. In real estate, this is a very broad definition. Investors can replace a multifamily home for a commercial office building, a duplex for an apartment building, etc. Investors cannot exchange a property for classic cars, art, etc. because they are not “Like Kind” investments.
- Both properties must be located within the U.S.
- The relinquished and replacement properties must be of the same value. Investors can exchange one property for multiple properties (Starker Exchanges), or multiple properties for one (additional note: see Construction/Improvement 1031 Exchange above for what to do if the replacement property is of a lesser value than the relinquished property).
- The replacement property can be of greater value than the relinquished property.
- Investors can carry over an existing mortgage to a replacement property.
- Acquisition costs can be applied to the value of the replacement property.
- Investor must pay taxes on any “Boot” received. Boot can be the result of cash, debt reduction or sale proceeds gained during the exchange.
- Investors have 45 days (from closing on their current property) to identify up to three replacement properties and 180 days to close on and acquire them.
Learn More About 1031 Tax Deferred Exchanges
For more information on 1031 exchanges, see 26 U.S. Code § 1031. If you are looking for new multifamily properties in the Columbus, Ohio area, contact Brown Multifamily Advisors.
Disclaimer: this information is for general use and is not intended to be taken as specific tax or investment advice. It is advised that you contact a tax attorney or investment advisor directly for specific advice regarding your case.