Looking to make money in real estate? There’s a tool that the big players in real estate investing use to help stretch their dollar and make them more money—it’s called a 1031 exchange. While it sounds a bit daunting (and if you just googled it, you’ll know that articles out there often use difficult language to explain it), we’ll break it down for you.
As with all financial topics that we discuss on our site, remember that we are not qualified tax accountants and while we do research our information extensively, you should speak to a qualified tax accountant to verify that this method will work for you.
What is a 1031 exchange?
You can use 1031 exchanges across most investing platforms, but for today’s purposes, we are just going to discuss 1031 exchanges in terms of real estate.
The 1031 exchange is part of tax code IRC Section 1031 that allows you to exchange one rental property with other properties and allows you to defer taxes on the gains.
For example: Let’s say you have a single-family house that you rent out in Pasadena. You like that rental property but you’d prefer to make more money off of your investment, so you would rather sell it and use that money to buy a new property.
If you sell it outright, you would owe capital gains tax (up to 20% of the sale of the house) on the property. This means you would have up to 20% less money to buy another investment property with. Obviously, that doesn’t sound like the best use of your investment money, so you look into doing a 1031 exchange.
With a 1031 exchange, you can take the lump sum amount you make on the sale of your first investment property and put it into several other properties without paying taxes on them—yet. You would owe taxes if you ever sold the homes you bought with a 1031 exchange, but that’s a discussion for another day.
Sound too good to be true? As long as you follow the rules, you can have this tax code be the bread and butter to your real estate portfolio.
1031 Exchange Identification Rules
The whole 1031 exchange identification process can get a little sticky, so here are the rules that you need to follow to complete your 1031 exchange successfully.
1. Properties must be like-kind.
In order to be properly identified, the IRS requires that the real property that you are relinquishing be like-kind to the property you are acquiring. This means you cannot exchange a single family home for a shopping mall, as those are very different types of assets. It does mean that you can exchange:
- A single family home for a duplex,
- A duplex for a multi-unit apartment building, or
- An apartment building for an office building.
As long as those properties are within the United States, are not your primary residence, and are long-term rentals (not fix and flip).
The replacement value must be greater than or equal to the original value.
That’s a mouthful.
Basically, this property rule means that the taxpayer can identify properties of equal or greater than the value of the original property, they can’t identify anything less.
This property rule is actually divided up into three sub-rules.
The first rule is that during the 45-day identification period (more on that later), you can find up to three properties—but no more than three—that you plan on buying with the 1031 exchange. You do not have to actually purchase all three properties—you can only purchase one or two, if you like—but you have up to three properties that you can identify.
Keep in mind:
- Identifying replacement property may take some time. Because of this, if you anticipate your house selling quickly, start looking for your replacement properties before you list your house for sale.
- The property that you end up purchasing must be of equal or greater value to the one you are replacing, so you’ll want to either identify properties that you are pretty sure you can close on with a combined value that is greater than or equal to the replacement value, or that each property separately are greater than or equal to the replacement value.
- The property must be unambiguously described with the street address (with unit number, if applicable) on the identification paper, and it must be signed and delivered to those handling your 1031 exchange by the 45th day after closing—regardless of if that day is a holiday or weekend.
200% Rule and 95% Rule
These rules are less common but go hand-in-hand.
The 200% rule states that you can identify more than three properties if the aggregate fair market value does not exceed 200% of the sale value of the original property.
That means if you sold a property for $400,000, you could find four or more properties to use in the exchange as long as the combined value did not exceed $800,000.
There is a caveat to this rule, however, and it’s called the 95% rule.
Many investors shy away from this rule because if you do identify more than three properties, you must close 95% of the value of all of the combined properties within the 180 days that make up the exchange period, or you will pay capital gains tax to the IRS.
Work within the 45-day identification period.
As we touched on above, you only have 45 days from the time that you close on your original property to identify your three properties (or more, if you are so bold) and submit them to whomever is handling your exchange.
That doesn’t mean that you can’t look before the close of your first property, however. In fact, we strongly encourage you to look for the properties before you close to make sure you have enough time.
This 45-day period also includes reverse exchanges. If you are doing a reverse exchange, the taxpayer must state in writing that they intend to sell and send it off no later than 45 days after the accommodator closes on the replacement property.
You have a 180-day closing period.
This rule states that from the time that you close on your original property, you have 180 days to close on the replacement properties. The 45-day identification period is within those 180 days.
You must use a qualified intermediary.
During the entire transaction, you are not allowed to touch the money made from the sale of your house. You must identify a qualified intermediary who has no vested connection with you to hold the money in their account until the close of the exchanged properties. There are companies that will do this for you for a fee.
These rules, while a bit complicated, can help you increase your portfolio substantially and make it so you virtually never have to pay capital gains tax on these properties. If you have any questions about the 3 property rule 1031 exchange, talk to your real estate professional.
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Need a real estate agent to help you with your 1031 exchange? Call a Clever local expert. They’re top-rated in your area and know their way around 1031 exchanges.Call us today at 1-833-2-CLEVER or fill out our online form to start.