Figuring Out How 1031 Exchanges Work
Section 1031 is one of the most useful provisions of the tax code, but it’s also one of the most misunderstood.
Section 1031 of the U.S. Federal Tax code once was an obscure tax break that deferred taxes on serial real estate deals and other types of investments.
Today, a 1031 is a familiar term and strategy for commercial real estate professionals. The provision allows investors to roll over profits from one investment to another without paying capital gains taxes (or paying minimal taxes) for as long as investors continue to swap similar properties.
Review some of the following reasons to consider a 1031 exchange – also called a “like-kind” exchange or a “Starker” exchange – to further build your commercial real estate empire:
- Defer taxes: The ability to defer taxes is the principal advantage of the 1031. When you defer taxes, you have more money to leverage and invest. Of course, taxes must be paid eventually, but you can buy and sell many properties before that time comes.
- Transfer wealth: Theoretically, commercial real estate investors can perform 1031 exchanges continually throughout their lifetime; defer taxes; and, upon death, pass those investments to children at a step-up cost basis, which could eliminate paying any taxes at all.
How 1031 Exchanges Work
Most 1031 exchanges are used for real estate deals, although the provision applies to exchanges of other types of property, like valuable artwork, as well. The two tricky parts of 1031 exchanges are the “like-kind” provision and time limits. If you mess up on either of those requirements, you can wind up owing a ton of taxes way before you had hoped.
- Like-kind provision: 1031 exchanges only apply to swapping similar properties. The swapping parameters are broad. The Internal Revenue Service (IRS) defines like-kind property as follows: “property of the same nature, character or class.” You can, say, exchange a residential rental house for vacant land or a strip mall for a ranch. You cannot, however, swap U.S. property for property outside the states. If you swap properties that the IRS does not consider to be like-kind, you’ll be taxed on the full amount of the sale.
- Time limits: The good news is that there’s no restriction on the number of times you can swap properties under the 1031 exchange. You don’t pay taxes until you, literally, cash out. But, timing is crucial when identifying and closing on a replacement property or up to three properties. You must specify a like-kind property within 45 days and you must close on the swap within 180 days of the sale of the previous property. If you have cash left over – called “boot” – it’s typically taxed as a capital gain.
You would have to read at least another 10,000 words to fully understand 1031 exchanges. Or you can call us, and we’ll help you decide whether this tax strategy is right for you. And if it is, we will help you identify properties, time sales, and make purchases so you can make the most out of this tax break.
Powered by HomeActions for Laura S. Rossinow, Broker associate, Keller Williams Realty, Newton, MA