1031 Exchanges Explained

April 1, 2022

The 1031 exchanges provision, also known as a like-kind exchange, is an economic machine with tons of benefits. According to the 1031 Builds America study, 1031 exchanges support approximately 56,000 jobs and contribute to GDP growth by between $55.3 billion and $69.1 billion.

Undoubtedly, the 1031 exchange property provision is beneficial to real estate investors. However, getting started can be a mammoth!

1031 Exchange Rules: What You Need to Know

How do 1031 exchanges work? This guide is about 1031 exchanges for real estate investors. It covers everything you need to know to get started.

What Is Section 1031?

Section 1031 is a provision in the  US Internal Revenue Code, allowing real estate property owners and investors to defer capital gains tax after selling like-kind real estate property like office buildings.

“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”

26 U.S. Code § 1031

Special Rules for Depreciable Property

According to IRS regulations, a depreciable personal property is a long-term asset eligible to book depreciation. Personal property can also be characterized as a depreciable tangible property or intangible property.

There are special rules contained in the IRS Publication 946 that apply for depreciable property.

To defer all taxable gain you must:

  • Own the real estate investment property;
  • Use the property in your business or other income-generating activity;
  • Determine that the property has a definable useful life; and
  • Determine that property should last for more than 12 months.

You can use two principal depreciation methods: the straight line and the accelerated depreciation. While the straight line method is a delayed depreciation method, acceleration is a more frontloaded method. So, you can front load expenses in the early years of ownership.

1031 Exchange Timelines and Rules

When choosing a replacement property, the primary requirement is a property with equal or greater value than the original property. This is also known as the like-kind property rule.  This rule allows the exchange of vacant land for a commercial building, rental house, or beach house.

You need to find assets sold within a 45-day window and identify a potential replacement property. That’s one of the time limit rules. You’ll also want to finalize the exchange process within 180 days, then transfer the new property to an exchange accommodation titleholder.

You can also opt for delayed exchange, simultaneous exchange, or reverse exchange options. Other 1031 rules include;

  • The three-property rule: the rule permits you to identify three potential properties despite their market value.
  • The 200% rule: according to the rule, you can identify an unlimited number of replacement properties. However, their cumulative fair market value shouldn’t exceed 200% of the value of the replacement property.
  • The 95% rule: according to the rule, you can identify an unlimited number of replacement properties. However, you can only acquire properties valued at 95% or more.

There’s no hard rule as to which of these rules you should stick to. you can use either of them to define replacement property identification.

What Is an Example of a 1031 Tax-deferred Exchange?

Here is a quick example of a 1031 tax-deferred exchange:

Jack owns an apartment building in Denver, CO, for $300,000. After several years, the apartment building value shoots up, and the new value is $1 million. Jack is also ready to sell the property through a real estate broker or a real estate agent.

He identifies a five-unit villa complex in Denver valued at $1 million and sets up the purchase through an exchange since the two properties have equal value. His $700,000 profit is deposited in escrow exchange funds and used to purchase the five-unit villa complex. This way, he defers paying taxes on the taxable income until he sells the villa.

1031 Exchanges Key Takeaways

Real estate investors benefit from 1031 exchanges through the elimination of tax liability. However, the process can be complex. Starting with finding the right real estate agent, an exchange company, or exchange facilitator to hold the exchange funds, filing fees, and handling closing costs. The good news is, we can help you. We’re located in Denver, Colorado. Be sure to contact Unique Properties today!

Image Source: HAKINMHAN / Getty Images

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