How Do You Qualify for a 1031 Exchange?

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Navigation: What is a 1031 Exchange?, How Do You Qualify for a 1031 Exchange?, What Qualifies as an Investment Property?, What is the 45-Day Identification Window?, What is the 180-Day Purchase Window?, What are the Four Types of Real Estate Exchanges?, Can I 1031 Exchange Into The BAM Capital Fund?

For owners of an investment property who want to sell off their current one while purchasing another, a 1031 exchange might be a good one option. A 1031 exchange is a tax-deferred exchange that allows property owners to defer capital gains taxes. However, this can only be done if the exchange fits certain qualifications.

Successful real estate investors often use this exchange mechanism because of its tax advantage. In fact, a 1031 exchange can be beneficial in a variety of situations.

Here we will be discussing what the qualifications for a 1031 exchange are, as well as how to perform the exchange.

What is a 1031 Exchange?​

A 1031 exchange in real estate is an exchange that happens by selling one investment property to purchase another. If a transaction qualifies as a 1031 exchange, you are not required to recognize a gain or loss.. Normally, you would have to pay capital gain taxes when swapping investment properties. But with a 1031 exchange, that may not be necessary. This gives investors the chance to try a different class of real estate, potentially without getting hit with a large tax burden. [1]

The term “1031 exchange” is taken from the Internal Revenue Service (IRS) code Section 1031 which talks about swapping one investment property for another. It is also known as a like-kind exchange or a Starker. If the swap meets the requirements, you will have either no tax or limited tax due at the time of the exchange. [2]

A 1031 exchange has plenty of moving parts that investors need to understand before attempting it. Ensuring that the exchange follows certain qualifications will help keep it tax-deferred.

Some investors use 1031 exchanges to gain profit on each swap while avoiding tax. Done properly, they can avoid paying tax until they sell for cash many years later.

Work with a qualified intermediary to understand the intricate details of a 1031 exchange. A qualified intermediary is a professional third-party company that assists in the exchange process. Their job is to keep investors from making mistakes that could affect their tax-advantaged sale.

How Do You Qualify for a 1031 Exchange?​

In order to qualify for a 1031 exchange and have the capital gain taxes deferred, the properties need to be considered “like-kind” in the eyes of the IRS. This only applies to business and investment properties, because personal properties do not qualify for a 1031 exchange. So while your home will not be accepted for a 1031 exchange, a rental property that you own may be exchanged for commercial rental property. [1]

A “like-kind property” is a broad term, which means most real properties are of like-kind. An apartment building would generally be considered like-kind to another apartment building. Even if the properties differ in quality or grade, if they are of the same nature or character, they can be considered like-kind. That said, real property in the US are not like-kind to real property outside the country. [1]

In order to qualify for a 1031 exchange, however, the property replacing the original one must be of equal or greater value. This means the equity as well as the market value of the investment property that you purchase will have to be equal or greater than what you sold the current property for. [1]

A “boot” is a gain realized in an exchange. If an investor generates boot, the exchange will not be completely tax-free. Boot can be generated by taking out cash from proceeds of sale, spending less than the exchange value on the replacement property, not replacing debt paid off on the relinquished property, over-mortgaging the replacement property, or paying debts not secured by a mortgage or deed of trust on the relinquished property. [2]

Aside from these qualifications, the new property needs to be identified within 45 days, and it must be purchased within 180 days. [2]

The final qualification for a 1031 exchange is to have the same title holder and taxpayer. This simply means that the name and tax return on the property title for the property being sold has to be the same name and tax return provided when purchasing a new property. One exception to this rule is if you are the only member of an LLC or limited-liability company that is passing down the property to you. [3]

There is no limit on how frequently an investor can do 1031 exchanges, provided that they do it properly.

What Qualifies as an Investment Property?

For a 1031 exchange, real estate properties that qualify in a 1031 exchange must be held for use in a trade or business for investment. “Held for investment” means that if the property is improved, it must be rented. This means that a taxpayer who, for example, allows his children to live in the property rent-free, or a taxpayer who holds the property but does not rent it, is not holding it for investment – and thus would not qualify for a 1031 exchange. [2]

What is the 45-Day Identification Window?​

There are a few different types of 1031 exchange, which we will discuss later on. But no matter which type you take part in, you only have 45 days from the close of the sale to find up to three like-kind properties. All the other qualifications mentioned above still apply, so keep that in mind.

This 45-day window is known as the identification period and is indicated in the Internal Revenue Service (IRS) code Section 1031. The taxpayer has this allotted time period in order to identify property that can potentially replace the one relinquished. [4]

This rule is in place because of a case known as the Starker case wherein the taxpayer was able to sell relinquished property on one day and acquire a replacement at a different point in time—five years later, to be exact. This rule no longer makes it necessary for an exchange to be simultaneous, while also giving investors some time to look for a replacement. [2]

What is the 180-Day Purchase Window?

After selling your current property, you will be given 180 days to purchase an investment property as a replacement in order to fulfill the 1031 exchange. [4]

If the investor is trying to exchange several properties at once, all sales and purchases still have to be completed within this 180-day window. This also gives them the opportunity to decide whether exchanging them at the same time is beneficial or not. By setting up multiple exchanges, the investor can have separate 45-day identification and 180-day purchase periods for each exchange. For those who want to enjoy a bit more flexibility when it comes to the timing of these transactions, going for multiple exchanges is the way to go. [5]

What are the Four Types of Real Estate Exchanges?

For property owners who are interested in participating in a 1031 exchange, there are four types of real estate exchanges that can fall under 1031: simultaneous exchange, delayed exchange, reverse exchange, and construction or improvement exchange. [6]

A simultaneous exchange is one type of 1031 exchange that involves acquiring a new property and selling an existing property on the same day. If either of them is delayed, then the exchange may be disqualified. One example of a simultaneous exchange is swapping deeds with the owner of another investment property. [6]

The simultaneous exchange can also be facilitated by a qualified intermediary, which is a third party that is specifically trained to structure and handle these types of transactions. Without the help of a qualified intermediary, you risk incurring a large tax burden from failing to meet the requirements of a 1031 exchange. [6]

A delayed exchange is the most commonly used type of 1031 exchange. A delayed exchange makes use of the 45-day identification period and the 180-day purchase period to complete the exchange. Property owners can relinquish or sell their investment property before purchasing another, as long as it is within that time period. [6]

A reverse exchange is unique because it involves finding an investment property first before selling your current property. Similar with a delayed exchange, you will have 45 days to identify which one of your investment properties will be relinquished. The 180-day purchase period also applies so you need to complete the sale within that time period. [6]

Finally, a construction or improvement exchange allows property owners to make a few improvements to the property before the exchange takes place. Under this setup, the property is placed with a qualified intermediary for up to 180 days. During this period, the owner can use the exchange equity to make the necessary improvements. However, for this to be free from taxes, all exchange equity has to be spent by making improvements to the property or as down payment. It also cannot be changed significantly because it needs to be the same property that was identified on the 45th day. After these improvements, the property still needs to be at equal or greater value. [6]

No matter what type of 1031 exchange you are going for, it is important to understand what it entails. Investors should be smart about these exchanges if they want to enjoy its tax benefits. Working with a qualified intermediary is highly recommended. 1031 exchanges can be useful if handled properly, so make sure you know what you are doing.

Can I 1031 Exchange Into The BAM Capital Fund?

The bad news is that you can’t 1031 into the fund. However, there’s still some good news. The losses that you receive as a member of the fund can potentially offset the gains you may have from the sale of that asset. So again, while you can’t technically 1031 into the fund, oftentimes you can achieve the same effect and not pay taxes.

Sources:

[1]: https://capital.thebamcompanies.com

[2]: https://morrisinvest.com/blog/2016/12/2/whats-the-difference-between-and-a-b-and-c-neighborhood/

[3]: https://www.millionacres.com/real-estate-basics/real-estate-terms/investing-multifamily-syndication/