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Understanding 1031 Exchange Rules and How It Could Soon Change

By July 19, 2021February 10th, 2022No Comments

One of the most important things for real estate investors to understand is the 1031 exchange. The term comes from Section 1031 of the IRS code. This is essentially an exchange of one investment property for another, which will allow your capital gains taxes to be deferred. This has the potential to help you save a substantial amount of money on taxes when buying and selling properties.

Of course, there are many rules in place regarding the use of a 1031 exchange. It is essential that you understand those rules, and that you understand some of the changes that could be coming soon.

What Is the 1031 Exchange?

As mentioned, this is the swapping of one property for another. Most of the time, the swaps are taxable as a sale, which would mean that you need to pay capital gains taxes. However, if the properties meet the requirements put forth by the IRS, you could eliminate the taxes at the time of the exchange. In some cases, you might not be able to remove all of the taxes, but you might be able to limit the taxes. Either way, you could save money if the properties qualify for the exchange.

The amount of capital gains taxes that you would have to pay can vary. The short-term capital gains rate would be between 10% and 37% for profits made on a sale within one year of buying the property. Long-term rates are between 10% and 20% for profits made on a sale after a year of the initial purchase date.

Like-Kind Properties

One of the first things that you need to understand about qualifying for the 1031 exchange is that the properties need to be like-kind. This means that the proceeds from the sale or disposal of a property need to be invested in a similar property that is equal to or greater than the value of the property you are getting rid of.

Like-kind can be a difficult term to understand. It doesn’t mean that if you are getting rid of an apartment building that you need to invest in another apartment building. Instead, you could opt to buy a strip mall or some land. Typically, they will just need to have a value that’s the same or greater than the property you are swapping from.

When you can use the 1031 exchange, it will allow you to grow your investment and defer the taxes. Interestingly, there is no limit on how many times or how often you can do one of these exchanges at this time.

 

Beware of the Time Limits

When you are going through a 1031 exchange, you have to be aware of some time limits that are imposed. You can’t simply sell one property and then eventually decide to buy another one in a year or so. There are two time limits that you have to follow.

You will have 45 days from the sale of the original property to then find a potential property that you will use as a replacement. You can opt to find more than one property to be used in the exchange, as long as they do not exceed 200% of the sale price of the property you are selling.

For example, if you sold your original property for $1million, the total value of the properties you want to acquire can’t be more than $2 million. Therefore, you could buy one property that’s worth $2 million, or you could buy several that total $2 million. You could also choose to buy properties that total less than $2 million, but not less than $1 million total. Remember, you need to have a value that is the same or greater than the property you are selling.

You will have 180 days from the sale of the original property to close on the new property or properties that you are buying. The exchange needs to be completed by that180-day mark, or you would be liable for capital gains taxes. It’s also important to remember that these are calendar days, not business days.

Types of 1031 Exchanges

In addition to the “standard” 1031 exchange, which is also called a delayed exchange, there are several other types of exchanges. This includes simultaneous and reverse exchanges. Let’s learn a bit more about how each of these works.

Simultaneous 1031 Exchange

With this type of exchange, you will sell one property and acquire the new property at the same time. This is not as common as a standard exchange. It could happen if there are two investors who are both interested in completing one of these exchanges and who want to swap their properties. They can do this and have it considered a 1031 exchange. In this case, both of the investors would benefit from not having to pay capital gains taxes on their properties.

Another example would be if there is a third party that sets up an exchange between buyers and sellers of investment properties that are both looking for a 1031 exchange. Working with a third party, in this case, can make it easier to find others who are interested in this type of exchange.

Of course, they still need to be like-kind properties. In these cases, since the sale and purchase take place at the same time, there is no need to worry about the time limits.

Reverse 1031 Exchange

What happens if you were to find a property that you want to buy before you can sell your original property? While this is uncommon, it does happen on occasion, and the reverse 1031 exchange will make it possible.

Here’s how it works. You can exchange the property. However, the time limits will still be in place, just reversed. You will have 45 days after buying the new property to determine which property you want to sell. You then have 180 days from that point to complete the sale of that property, which will finalize the exchange.

What Changes Could Be Coming?

Real estate investors have enjoyed the 1031 exchange for along time, but there is potential for that to come to an end. During his campaign, President Biden proposed the idea of eliminating the 1031 exchange as a means to use the tax money the country would gain to pay for things like elder care and child care. While this was only a proposed idea at the time, it is now being discussed as part of Biden’s tax plan.

One of the changes that were proposed was increasing the capital gains tax rate to 39.6% for people who are making more than a million a year. Biden no longer says that he wants to get rid of the 1031 exchange. However, he does want to limit their use. There is a proposal put forth in May that limits the amount of capital gains from investment property sales that can be deferred to $500,000 a year for individuals and $1 million for married couples. Currently, there are no limits.

This has caused many investors to scramble to make their exchanges or to sell off their real estate before something like this were to happen. Regardless of what happens with 1031 exchanges, it is more important than ever for real estate investors to pay attention to the changes that are happening. This will allow investors to make the right decisions when the time comes.