1031 Tax Exchange
This past winter we purchased and rehabbed a property in the Clintonville neighborhood of Columbus, Ohio. We purchased and rehabbed this property entirely with profits from other properties we had sold, much of which would have otherwise gone to federal capital gains taxes. We were able to do this and avoid a large tax obligation using a 1031 like-kind exchange. A 1031 like-kind exchange is part of the IRS tax code that allows a person or business to avoid, or rather defer, paying capital gains taxes on the sale of an asset, by using the proceeds of the sale to purchase one or more similar, or like-kind assets. In my case the assets I’m referring to are real estate. A 1031 like-kind exchange can be a valuable tool that allows investors to realize the full returns of their investments and increase their buying power as they continue to invest those gains into new opportunities. But these exchanges can be pretty complex, especially in a competitive real estate market, as there are a number of guidelines that need to be followed and frankly seem designed to trip you up at different points along the process.
Some of the notable guidelines include:
The use of a qualified intermediary to facilitate the exchange and hold your money, typically this will be a real estate attorney.
Investors have deadlines of 45 days after the sale to identify a property or properties to purchase, and 180 days after the sale to finalize the purchase(s) and complete the exchange.
In order to defer all of the capital gains the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Generally speaking this means if you are selling a property with a mortgage, you will need to carry the same or more debt on the new property.
The only guideline that can be somewhat forgiving is the definition of like-kind, which in terms of real estate is basically any property that you are not or will not be using as your primary residence. For example, you can sell a large apartment building and then use that money to purchase land. You wouldn’t however be able to use that money to purchase equipment needed for your business.
There are also a variety of different types of exchanges designed for different types of scenarios; there are simultaneous exchanges, reverse exchanges, improvement exchanges and the most common, a delayed exchange. A delayed exchange involves many of the guidelines already mentioned and is characterized by first selling a property and then using those proceeds later to purchase a property.
I’ve done two 1031 exchanges so far, the first being a standard delayed exchange. The latest exchange in which we acquired the Clintonville duplex was using an improvement exchange. The improvement exchange can be similar to the delayed exchange with one notable exception. In order to make improvements to a property using 1031 tax deferred proceeds, at closing the property is handed over to the intermediary while improvements are being made. After improvements are completed, which still has to be finished within the 180 day deadline, the property is then transferred into the investors name and the exchange is complete. This can present a major challenge if the investor plans to finance the purchase of the property as most lenders probably won’t want to finance a property that is going to an intermediary.
Lastly, utilizing a 1031 exchange doesn’t necessarily mean that you will never have to pay capital gains. Once you sell and pocket the proceeds of the property you purchased using a 1031, or the last property in a chain of exchanges, you will need to pay capital gains on that sale. But at that point your overall tax burden will be greatly reduced versus having paid capital gains on each individual sale.
1031 exchanges can be tricky and confusing, but as long as you’re working with professionals that understands the guidelines, the process will go much more smoothly. Contact me if you have any questions about 1031 like-kind exchanges.