Real estate can be a profitable investment, but once the investor is ready to sell, they also have to be ready to take a hit with the hefty capital gains tax. For investors who want to delay paying that tax and who are willing to stay in the real estate market, the IRS does offer one solution: the 1031 exchange. The 1031 exchange allows property owners to trade property held for business or investment purposes for a “like-kind” property without paying a capital gains tax right away. A 1031 exchange does not eliminate the tax, just defers it. If and when you sell the property outright in the future, you will still owe that capital gains tax.
To facilitate this process, property owners will need to work with a Qualified Intermediary. These professionals look out for the interests of both the buyer and the seller so that the trade meets all of the legal requirements for a 1031 exchange.
Property owners can engage in four different types of 1031 exchanges:
- Simultaneous Exchange
- Delayed Exchange
- Reverse Exchange
- Improvement Exchange
Simultaneous Exchange
A simultaneous exchange is true to its name: two property owners are just swapping properties. This could be compared to neighborhood kids trading baseball cards. One kid hands over their card and immediately gets one back in return. This even works if the first kid hands over two less valuable cards and receives one more valuable card in exchange. The key is that each owner relinquishes their property and receives a replacement property at the same time. If there is even a small delay, the IRS might disqualify the exchange from 1031 benefits.
The potential trouble here is that property owners may have trouble finding a trading partner willing to make a fast swap or may run into issues getting the legal aspects in order so that the transaction can happen seamlessly. While it is technically possible to make this type of exchange without a Qualified Intermediary, that leaves more room for error and less flexibility in converting the exchange into a different type if needed.
Delayed Exchange
A delayed or deferred exchange is the most common type of 1031 exchange. In this case, a property owner has found a buyer for their property, but they have not yet secured a replacement property. This is where a Qualified Intermediary becomes essential, since they will need to hold onto the cash received from the sale until a replacement property is found.
Deadlines are important when it comes to a delayed exchange. The owner must find a replacement property within 45 days of that first sale. The IRS allows 180 days for the owner to actually close on this property—meaning that’s the maximum amount of time that the Qualified Intermediary can hold onto the sale proceeds.
Reverse Exchange
A reverse exchange is the opposite of a deferred exchange: the property owner has found a property they want to purchase, but they do not yet have a buyer for the property they currently own. This process requires the help of an Exchange Accommodation Titleholder, an entity such as a limited liability company that may be set up to receive the title to the new property—at least, initially. This entity is needed because the property owner cannot own both properties at the same time and still qualify for 1031 exchange benefits.
With the reverse exchange, the property owner has 45 days to legally release their original property. They also have 135 days to find and complete the purchase of a replacement property. Property owners may run into a few roadblocks with this type of exchange. One is that many banks will not fund this type of purchase. Another is that the deed transfer process may be complicated depending on the state where the property is located. However, if the logistics can be arranged to work within the deadline, this can allow the investor to snatch up the ideal replacement property when the opportunity arises.
Improvement Exchange
The last option is an improvement or construction exchange. This type of 1031 exchange provides a way for a property owner to upgrade the replacement property by using the deferred tax amount, also known as the exchange equity. If an investor wants a replacement property that is not quite up to standards—say it needs improvements in order to be used as a rental property—this can be a great option. Any construction must be completed before the 1031 exchange is complete, since this is considered part of the exchange.
To complete an improvement exchange, the property owner must identify a replacement property, relinquish ownership of their current property, and allow the Qualified Intermediary to hold the proceeds from the sale. The Qualified Intermediary then pays for any property renovations. The details for any improvements must be specifically outlined as part of the sales contract and must occur within 180 days of the sale. Once the renovations are completed, the investor can finally take ownership of that property.
Summary
Whether you are looking to do a simultaneous, delayed, reverse, or improvement exchange, the key is to understand the requirements for qualifying for the 1031 tax deferral benefits. The common denominator in all of these methods is that a Qualified Intermediary must have control over the funds during the exchange so that property owners never hold any cash from these sales and never technically own both properties (the original and the replacement) at once. If you abide by this rule and follow the timeline requirements for your chosen method, you can reap the rewards of deferred tax payments and more time to build out your long-term property investment strategy. For expert guidance building out a tax plan that maximizes your investment profits, reach out to a Certified Tax Planner today.
