Most people are aware of the fact that when you sell a long term investment such as real estate or stocks, you have to pay taxes. And these taxes don’t come cheap – currently capital gains tax is 15%, and California has its own capital gains tax of 9.3%. To put this in perspective, if you bought a property for $500,000 and years down the line you sell the same property for $1M, on that $500k profit you have to pay $121,500…PLUS your cost recovery recapture. That’s a HUGE chunk of cash. …but did you know there’s a way you can defer that and not even pay a SINGLE PENNY?? It’s called a 1031 Tax Deferred exchange, 1031 exchange for short. A 1031 exchange is when you sell your property and buy another like-kind property within a certain time frame and follow specific rules.
Now you have to note, that this is a *tax deferred* investment strategy. What that means is that you will just keep rolling over what you owe in taxes to some future date. If you ever decide to completely abandon investing in real estate altogether, you will have to pay it all back. The idea though is to continuously roll it over indefinitely until you pass away. Now that we have that explained, let’s get to how a 1031 Exchange works shall we?
Let’s say you bought a property 10 years ago for $1M. Today, you can sell that same property for $2m. The first step that needs to be taken when doing a 1031 exchange is the process of finding a good qualified intermediary, or QI. The QI is a company that will be the “middle man” throughout the 1031 exchange process. My first tip on this – DON’T shop around for the cheapest one. Find a reliable company that has been doing this for years and pick them…even if they cost a bit extra. This is not something you want to bargain shop for.
Once you find the qualified intermediary, you need to inform them of your plans and that you are in escrow with a property. Now that everyone is in the know, here’s where it gets tricky. There are two key timeframes you have to keep track of with a 1031 exchange. From the date you sell your property, you have 45 days to identify a new property or properties. The second is that you have 180 days to CLOSE on the new property you identified; again this starts from on the date you sell your property. One thing that must be made clear up front is that these dates are non-negotiable. This means that if you can’t identify a property within 45 days, the 1031 exchange is dead and taxes are automatically due when you file your return. If you can close because of financing issues within that 180 timeline, again, the 1031 exchange isn’t valid.
With that being said, let’s get into some of the details. First, the 45 day identify period. Within this 45 day period, you can choose up to 3 different options. The first and most common option is the “3 property rule”. The rule is that you can identify a total of 3 properties at any price. Most investors use this option because once they sell their property, they upgrade to an even larger one. However, once in a while investors want to sell one property and buy multiple smaller properties. This is where the second option comes in – the “200% rule”. The second option is that you can identify an UNLMIITED amount of properties, but they can’t total more than 200% what you just sold your property for. In our example, we sold our property for $2m. We can choose as many properties as we want, so long as their total value doesn’t go above $4M.
The third option which is sometimes referred to as the “95% closing” rule, can be a bit tricky. It is similar to the 200% rule where you can pick as many properties as you want with one major difference. There is no price limit. You can pick 4, 10 or even 20 properties totaling an infinite value. The catch is you must CLOSE on at least 95% of them. This is usually best left to the savvy investor who is buying everything all cash. Once you get the identification rules down, the 180 day closing time period is fairly straight forward.
So how now that you know the timeline rules, how does it all work? The way it works is just like a regular sale, but with the qualified intermediary acting as the “go through” person. Once the seller has their money in escrow and everyone has signed their paperwork, two transactions will take place simultaneously. Instead of selling directly to the seller, you will sell to the QI who holds title temporarily. The QI will now sell your old property to the new buyer immediately. The funds from the buyer are then given to the QI to hold. This qualified intermediary acts as a trusted holder for your funds during the 1031 exchange time period. Throughout the process, you are not allowed to touch ANY funds. If you do decide to pull any funds out, it’s considered “boot” and will become taxable the second it leaves the QI’s control.
Now that we have gone over all the basic rules of a 1031 tax deferred exchange, let’s get into some of the more common questions. By FAR the most common question I get is in regards to the “like-kind” statement. If someone sells an apartment, do they have to buy another apartment, or can they buy an industrial warehouse? The answer is YES. Like kind means real estate – period. If you sell real estate – be it an apartment complex, an office space or a piece of raw land – you can buy other real estate. You can sell a piece of land, and buy a shopping center, you can sell your industrial warehouse and buy an apartment complex, and you can sell your investment home and buy a fourplex.
Speaking of homes, I’ll touch on the second most common question I get. Can I 1031 exchange my primary residence?? Well…you don’t need to! In section 1034 of the internal revenue code, you can sell your primary residence and not have to pay taxes for up to $250k if you’re single or $500,000 if you’re married. Finally, is it possible to buy a property FIRST, and THEN sell my property with a 1031 exchange? The answer is yes, but this is a called a REVERSE exchange. It is a more expensive and riskier version of the regular 1031 exchange, primarily because you must find a BUYER who will CLOSE on your property within 180 days after buying your new property. The same role with the qualified intermediary occurs. You sell the qualified intermediary your property after letting them know in advance what your plan is, and then they sell the property to the new buyer.
When it comes to the value of the new property or properties, the basic point is this. You have to put in equal or more money, and buy an equal or larger valued property. The loan amount is completely irrelevant so long as those two amounts are satisfied. Remember, 1031 exchanges might not be the best option for every single person, but it’s usually the most preferred option for most investors. If you’re looking to avoid paying capital gains tax, the 1031 exchange is by far the most common financial technique…now that’s good to know. 🙂
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