Real Estate Investors Guide to a Successful 1031 Exchange, Part One
Let’s start from the beginning. A “1031 Exchange” or “like-kind” refers to the tax benefits received under US Internal Revenue Code Section 1031; formal cited as, 26 U.S.C. §1031 as regulated and enforced by the IRS. Real estate investors use the tax benefits under 1031 to defer and reduce capital gains taxes that would otherwise be due for the tax year in which a property was sold. Simple right? Well, not really; it is, after all, the IRS. Certain criteria must be met in order to have a successful 1031 exchange. But, lets not skip too far ahead. First, we will start with the purchase of an investment property that qualifies under Section 1031, then we will move on the the sale of that property, the identification of the “new” property, the proper transfer of ownership, use of Qualified Intermediaries and finally the future tax consequences.
It Must Be an Investment Property
The IRS does not consider a second home to be an investment property. If you are living in your upper Michigan home in the spring and summer and your Florida condo in the fall and winter, then you cannot upgrade that Florida condo to a beachfront condo and avoid paying capital gains taxes by claiming it’s an investment property. Second homes are not successful 1031 exchange material.
The Properties Exchanged Must be of “Like Kind”
First, the properties being exchanged must be of “like kind.” In other words a personal property investment, like a valuable painting, cannot be exchange for a house, which is a piece of real property. The two are simply not alike enough to qualify and the 1031 exchange would fail and taxes would be owed for any capital gains or profits made from the sale.
While qualifying “properties” under Section 1031 include things other than real property, commonly referred to as real estate, for the purposes of this article we will only be discussing real estate exchanges. Qualifying real estate can be in almost any form. The most common properties used in 1031 exchanges are commercial and commercial/multi-family properties such as office buildings, strip malls, and apartment complexes. Undeveloped land, whether a single plot or a large parcel, is also frequently exchanged under 1031. Fortunately, for the small investor single family homes, individual condominiums, and small 2 to 4 unit multifamily residential properties qualify as well.
The exchange of one type of real estate, say a parking lot, for another type, like an apartment building, will almost always qualify as being of “like kind.” A small or first time investor can buy a condo and then sell it at a profit and exchange it for single family home, duplex, or even a small commercial building and still have a successful 1031 exchange. Once the “like Kind” test is met, we then move on to value.
The Properties Must be of Equal or Greater Value
A quick word of advice before we move forward. For a successful 1031 exchange, you must be in it for the long haul. If you’re a buy, hold, sell, take your profit and repeat kind of investor, then 1031 exchanges are not for you. There is nothing wrong with that type of real estate investing, but 1031 exchanges do NOT work for short term investments or house flipping. Successful 1031 exchanges are for long term investors who seek to use one property to buy another, more valuable or desirable property without liquidating any of the profits. In most cases, a successful 1031 exchange includes an additional monetary investment in the new property. Why is this? Well, because Section 1031 requires that the exchange be for a property of equal or greater value of the original properties sales price.
Example: If you buy a condo for $100,000, then sell it for $150,000 and purchase another condo for $110,000, then you do not have a successful 1031 exchange. Why? Because the IRS will look at you and say where is the continuation of investment? You took a cash profit and only reinvested a small portion of the profit into another property. You owe capital gains taxes on the whole profit of $50,000 even though you reinvested a portion ($10,000) into a new property.
Turning the example above into a successful 1031 exchange would go something like this. You purchased the original condo as an investment for $100,000. You later sold the property for $150,000 and along with meeting all other requirements you use the proceeds from the sale to purchase a single family home as an investment for $155,000 investing an additional $5,000 cash into the new property. Viola! A successful 1031 exchange. Your accountant can sleep well tonight and you just made a $50,000 profit without owing any taxes on it this year and your now the proud owner of a home valued at $155,000 instead of the original $100,000 condo. Pay attention! This is how you become wealthy; especially if you start to leverage it, but that’s another subject for another time. Right now let’s just concentrate on avoiding taxes (Please note, tax avoidance is legal, tax fraud is a felony; know the difference.)!
Hands Off the Cash: You can never Have Control of the Money
Listen-up! This is where most mistakes happen. You absolutely cannot have control or access to the proceeds from the sale; not even for a minute. Unless there’s a simultaneous closing where the funds from the sale of the first property pass directly to the closing agents trust account and then, are almost immediately used to fund the closing on the new property, then a Qualified Intermediary must be used to hold the funds (more on Qualified intermediaries in Part 2). You, as the investor, cannot have control of the funds. If the funds pass to you and you later use them to purchase a new investment property, even if all other requirements are met, you do not have a successful 1031 exchange and you will owe capital gains taxes. When conducting a 1031 exchange be sure to work with a Realtor, attorney, closing agent, and accountant all of whom understand real estate 1031 exchanges. This is tricky, but certainly possible if the real estate professionals understand the requirements of a successful 1031 exchange.
More often than, however, the closing dates will be separated by a significant time period. Using a qualified intermediary is the best way to be sure that you are in compliance with Section 1031. Qualified Intermediary are third parties who are
Tick, Tock, Tick Tock: Time Restrictions on 1031’s
The IRS won’t let you just sit on all that cash waiting for the perfect property to come around and they’re not going to forget it’s sitting there either. Section 1031 place time restrictions on purchasing the exchange property. The time starts ticking the minute the funds are distributed from the sale if the property being exchanged. Ideally, the exchange will take place simultaneously. This means identifying and securing a contract on the new property with a closing on the same or day after the sale closes on the first property. If it doesn’t then the Section 1031 requires you to identify the new, like kind, property within 45 days of closing on the sale of the original property, during which time the funds are held in escrow by a Qualified Intermediary (more on Qualified intermediaries in Part 2). I you identify the new property and close on it within the 45 days, then no formal notice needs to be sent to the IRS. If, however, the closing date goes beyond the 45 days then formal notice must be sent to the IRS using; this should be handled by the Qualified Intermediary on your behalf or by your accountant.
Please watch for Part 2 of this article coming soon. I will place a link here when it’s published so bookmark this page and check back. Thank you!
About the author: Oscar is a practicing, Florida attorney, Realtor, and Florida Supreme Court Certified Mediator. He began working in real estate as a Realtor in 1994 and later went on to become a real estate attorney in 2002. From 2002-2005 Oscar was the sales director for Ballast Point homes LLC. During his tenure with Ballast Point Homes, he managed a sales team that produced over 55 million dollars in condominium and townhome sales. With over twenty years of experience, Oscar represents buyers, sellers, business owners, other Realtors, and Brokers with professional, personalized service. In addition to residential sales, as an attorney, Oscar has written and negotiated many commercial and residential contracts and leases. He currently represents several local businesses including two restaurant chains but, prefers to focus on residential and income property sales in St. Petersburg and the beaches.
A native of St. Petersburg, Florida and a second generation Gator, he received a B.A. from the University of Florida and a J.D. from Stetson University’s College of Law. He is currently an MA candidate at American University’s School of International Service with a focus on International conflict and dispute resolution. Oscar is US Army veteran and former Judge Advocate. As a captain in the Army JAG Corps, he served in the 3rd Infantry Division and then as Chief of Client Services, Schweinfurt, Germany and Chief of Criminal Justice for the 200th MP Command, Ft. Meade, Maryland. He is a certified VA attorney representative and an active member of VARep, an organization of real estate professionals dedicated to representing and education veterans. Oscar focuses his passion for real estate on providing exceptional client services. He lives in St. Petersburg with his wife and twin daughters. Oscar and his wife, Melissa, own and manage vacation rental properties in Pinellas and Manatee County, Florida.