What Real Estate 1031 Exchange Rules Must I Follow?
Rule 1: Like-Kind Property
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.”
Like-Kind Property Definition: Like-Kind property is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” (4) In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
Exchanging an apartment building for a duplex would be allowed. Exchanging a single family rental property for a commercial office building would be allowed. Exchanging a rental property or vacation rental for a restaurant space would be allowed.
EXCEPTION: It’s important to note that the original and replacement property must be within the U.S. to qualify under section 1031.
**Another fun fact: 1031 Exchanges can include more than two properties. For example, you can exchange one property for multiple replacement properties and vice versa: you can exchange multiple properties and for one larger property. As long as the new properties are like your original properties, you’re good to go. Do yourself a favor and get a good qualified intermediary to assist you.
Rule 2: Investment or Business Property Only
A 1031 exchange is only applicable for Investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia. If you were to get married, and move into the home of your partner, you could not exchange your current primary residence for a vacation property. If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.
Rule 3: Greater or Equal Value
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)
Rule 4: Must Not Receive “Boot”
A Taxpayer Must Not Receive “Boot” in order for the exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”
Rule 5: Same Tax Payer
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.
For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, he can purchase property in his name, and be in compliance with the 1031 code.
Rule 6: 45 Day Identification Window
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
Rule 7: 180 Day Purchase Window
It’s necessary that the replacement property be received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
As you might realize, there are many rules and qualification requirements that you must comply with in order to perform a successful exchange. To sum things up, the biggest advantage of using this strategy is that you can avoid having to pay capital gains taxes on the sale of an investment property. This can be a huge benefit for real estate investors who know which markets are primed to grow next. It can also be a huge downfall for beginning investors, or those who don’t understand the changing real estate landscape. If you don’t, you risk falling victim to one the biggest disadvantages is the reduced basis for depreciation on the replacement property.
This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. In other words, if you want to maximize the benefits of your exchange, it’s important that you choose your replacement property (or properties) wisely, investing in a market that has good potential for growth in the future.
Like-Kind Exchange Benefits To Take Advantage of Now
At it’s core, a like-kind exchange is executed for one reason: to defer taxes. What many people don’t realize is that it can do so much more than this.
At Lee & Associates Investment Services Group, we advise our members to exchange their high-value investment property for turn-key, cash flowing, investment properties in the strongest U.S. markets. We do this to help them leverage their tax-savings to invest in properties that will (a) generate more cash flow every month, (b) take less time to manage, and (c) give them more freedom.
Here’s an example:
“My favorite [like-kind exchange] success stories was when a woman named Lisa came to our office in mid-2007 and told us she had 3 properties in Ontario, California worth about $400,000 each. She said they were very old and in need of repair, and each brought in about $1200 per month in rent. Lisa really wanted to quit her job and retire but she didn’t think she could live on the net income from those properties, which was about $2400/month (net refers to the remaining cash flow once expenses are paid.)
I was very happy to be able to look Lisa in the eyes and say, ‘I’ve got great news for you. You can actually retire today.’
I explained that she could exchange her three old, dilapidated California properties in very rough neighborhoods for nine brand new properties in highly desirable areas.
Here’s how the numbers would look: She owned the 3 Ontario properties free & clear. They would sell at that time for about $400,000 each. Thanks to Section 1031 of the US tax code, she could exchange those properties tax-deferred for 1.2 million dollars worth of property in Texas.
The average home price in Dallas, Texas was $122,000 at the time so finding 9 high-quality properties for under $130,000 each would be easy. And even more surprising was that those properties would easily rent for $1200 each.
Remember, Lisa was getting $1200 rent on just three properties in California, and those homes were in total disrepair. Maintenance and repair costs were eating up the cash flow.
Fortunately, Lisa listened to me and took the leap, and the results were astounding. She sold the Ontario homes and I helped her exchange them for nine really lovely Dallas properties. I also helped her put all those properties under excellent property management, so she no longer had to suffer as a typical landlord fixing toilets.
Her gross income went from $3600/month to $10,800/month and her net income went from effectively zero (due to the old homes requiring so much repair) to $6500 in monthly net income. Plus, the homes she bought in Texas were brand new and would require little or no repair for years.”
— Excerpt from Kathy Fettke’s (Real Wealth Network Co-Founder and Co-CEO) book Retire Rich With Rentals.
A 1031 Success Story
“We had a house in San Francisco. It was a rental property, and we knew we wanted to sell it. But if we did sell it, we would have to pay a pretty hefty capital gains tax. So, we knew we had to do a 1031 exchange. Do you have any idea how many rules there are? It’s insane. We were looking at making about $1.5 million, but there was no way we could buy “like-kind property” in the Bay area, and actually make a profit. That’s when we heard Kathy Fettke on the radio, and what she was saying sounded too good to be true. It really did.
We were very cautious when we first found Real Wealth Network, so we took our time. But eventually we trusted them. Their whole ideology is about teach you how to be a great investor, and it really works. I mean, I’ve learned so much more in the last year or so than I ever knew about rental property before.
It was amazing how much father our money went outside of the Bay Area. I know the old rule of thumb was, “You have to be around your rentals.” But with technology, the internet, and a trustworthy team, this isn’t necessarily true anymore. At least it wasn’t true for us.
The result: We sold the one property in Bay area and we turned around and invested in about 20 properties, increasing our cash flow six times.” — Claudia & Julian Fraser
Note: Today Claudia and Julian own over twenty properties in 3 states, and they’re bringing in about $15,000 of net cash flow every month. It all started with a successful like kind exchange.
Do you feel inspired now? Hopefully the answer is yes by now. Why?
Because everyone has the ability to end up with passive income from real estate – even if you don’t have any money to start with. All you need is a solid education to know how to do use this powerful strategy correctly.
This article is just a basic overview of how to do a 1031 exchange in 2018. Hopefully, you now realize how important it is to understand the intricacies of real estate investing, real estate market cycles, and growth opportunities before you even think about getting started. If you’re a beginner, you should start by learning how and where to invest in real estate in 2018. For those of you who are more experienced, take some time to get a solid understanding of rules and regulations. You’ll need to know them like the back of your hand, or you still might end up with a huge tax bill.
Truth be told, a 1031 tax-deferment is incredibly complicated, even if you’re a career investor. Even a small mistake can jeopardize the deferment of your capital gains taxes. This is why most investors seek professional help.
Got questions contact our 1031 expert Robert Leveen at firstname.lastname@example.org