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How Do 1031 Exchanges Work?
January 6, 2021

How Do 1031 Exchanges Work?

by The CE Shop Team

Learn the Ins and Outs of How 1031 Exchanges Work in Real Estate

Despite all the political hoopla of the past year, we can all agree that taxes are despicable. There’s nothing more depressing than opening a pay stub and seeing Uncle Sam taking a big ole chunk of your hard-earned money. But while taxes may be a certainty, Uncle Sam also created a tax-deferment rule for real estate that allows you to invest without fear of a tax bill coming your way anytime soon. It’s known as Section 1031 of the United States Internal Revenue Code.

Referred to as “1031 exchanges,” this rule allows you to swap one investment property for another without having to pay capital gains taxes right away. While this may seem simple at first glance, there are a few items and rules we should explain before you share this tax-deferment vehicle with your clients.

What Is a 1031 Exchange?

In simple terms, a 1031 exchange allows for an exchange of investment properties to defer taxes due on capital gains. To help you fully understand what this means, let’s look at an example.

Brett Salisbury is a full-time worker who currently generates enough income to qualify for the highest tax bracket. He wants to invest in real estate, so he purchases an empty five-acre ranch just outside of Atlanta for $100,000. He holds onto the property for the next five years, and the price appreciates to $150,000. Once he sells that plot of land, he will be liable for taxes due on the $50,000 in capital gains.

Because Brett is in the highest tax bracket, he will most likely have to pay Uncle Sam 20% on the $50,000. However, his agent tells him about Section 1031 Exchanges, which prompts Brett to take his $150,000 and buy a similar property elsewhere. By enacting this exchange, he can now allow his investment to continue to grow tax-deferred until he retires without generating income (i.e. potentially paying 0% taxes after the final sale).

Brett can continue to complete as many 1031 exchanges as he wants as long as the properties are considered to be “like-kind.” This broad statement expands beyond other similar ranch properties that Brett can purchase; it could work for an apartment building purchase or an exchange of one business for another (if Brett had owned a business instead of land). This rule can even be applied to former primary residences or vacation homes. However, there are many restrictions and extra rules you’ll need to research and consider when setting up this exchange.

Key Rules and Takeaways for Section 1031 Exchanges

Timing Rules With Delayed Exchanges

Because finding “like-kind” properties can take some time, there are specific rules to consider when attempting to enact a delayed 1031 exchange (also known as a Starker exchange). This exchange’s name stems from the 1979 court case that saw the Starker family defend their claim against the IRS, saying that tax deferment on these properties does not have to occur simultaneously. It’s important to note that the phrases “1031 exchanges” and “Starker exchanges” are used interchangeably amongst real estate professionals because almost every 1031 exchange is a delayed exchange.

With that in mind, a Starker exchange traditionally requires the exchanger to hire a qualified intermediary or middleman to receive the money from the sale and use those proceeds to swap for another property within a specified amount of time. This third-party allows exchangers to properly make their swaps without having to incur a tax hit upon sale. In order to execute a Starker exchange, you must observe the following timing rules:

45-Day Rule

Upon sale of the property, the middleman will receive the cash. If you as the property owner take receipt of the cash, the exchange will be invalidated. Within 45 days of the sale, you must address a written designation to the middleman denoting one of three properties you wish to purchase, though ultimately only one of the properties needs to be purchased. In some instances, you will be allowed to provide more options. It is in your best interest to provide as many choices as possible. More choices provide flexibility when the time comes to make the swap.

180-Day Rule

Within 180 days of the property’s sale, you must close on the new property. Please remember that the 45-day and 180-day rule run simultaneously. This means you’ll only have 135 days to close on the new property once the middleman receives the money.

The Boot: Tax Implications

You may have excess cash on hand after the purchase of the new property. This cash is known as the “Boot.” Referring back to our investor Brett Salisbury: if his new purchase is $140,000, his intermediary will pay this money after 180 days. This purchase qualifies as capital gains and can be taxed as such. This rule also applies to mortgage and other debt vehicles. His new mortgage may cost less, but he’ll still be designated a $10,000 “Boot” that he must pay taxes on.

Vacation Homes: What You Need to Know for a 1031 Exchange

Back in 2004, Congress passed a law that restricted the exchange of vacation or second homes held for personal usage, noting that these properties do not qualify for a tax-deferred exchange. However, that does not fully exclude these types of homes from 1031 exchanges.

Rules for Vacation Home Exchanges

  • The owner must own their new home for 24 months after the exchange.
  • During each 12-month period, the owner must rent the unit at a fair market price for at least two weeks and limit personal usage to two weeks or 10% of the number of days rented during the 12-month period.

In this situation, renting at the fair market price establishes the vacation home as an investment property, allowing you to complete this swap under the law.

Now, what if you’ve already set up residence as a second home for an extended period of time? The best option for gaining tax deferment upon a swap would be to find renters for the home, have them rent it for at least six months to two years (there is no standard, but longer is better), and require fair market rent. If you obtain renters during this time at the proper rental price while acting in a professional manner, you should be able to convert the property into an investment and take advantage of a 1031 exchange.

House Hacking Tips

There is more than one way to gain an advantage over dear old Uncle Sam. Watch the video below and learn more about house hacks for limiting out-of-pocket mortgage costs and capital gains taxes on your appreciating properties.

Want to Learn More About 1031s With The CE Shop?

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