The Basics of a 1031 Exchange and The Different Kinds of 1031 Exchanges
At some point in your life, you may either encounter some money or work your tail off to make enough money in order to start purchasing real estate for investment purposes. Whether it is a single-family house, condominium, office building, or a plaza, one thing these properties all have in common is that they are types of properties that a real estate investor would be looking to buy. One tool that real estate investors use to help them save, or put off, capital gains taxes is to do a 1031 exchange. What exactly is a 1031 exchange and why is it important if you plan on dealing with investment properties?
A while back, the Internal Revenue Service (“IRS”) released rules governing deferred exchanges, which can be found in Section §1031. Under these rules, real estate owned as an investment or used in a trade or business can swap their property tax-free for “like-kind” real estate. Typically, when a property is sold, the seller of the property will usually be stuck paying the capital gains they receive from the sale. However, under a 1031 exchange, the seller is allowed to prolong paying capital gains taxes by essentially “swap out” the properties for another like-kind property.
For example, Igor the Investor has bought a commercial plaza for $500K and decided to spruce it up and get some better tenants with long leases. A few years down the road, Igor sees another commercial plaza hit the market for $800K and realizes he has to have it. With the work Igor put into his plaza, he was able to sell it for $800K and then a few weeks later, he buys the new plaza for $800K. By doing a 1031 exchange, Igor avoided paying a capital gains tax of about $300K.
When performing a 1031 exchange, there are three (3) basic steps to follow:
1. Identify the property you want to buy and sell.
2. Choose a qualified intermediary.
3. Tell the IRS about your transaction.
As mentioned above, the first step requires you identify the property type. Although it does not have to be the same exact type, quality, or grade of property, it must be similar. This would mean that you cannot use proceeds from a single-family rental property to buy a commercial plaza. Next, you must choose a qualified intermediary, which is also known as an exchange facilitator. The qualified intermediary will hold the funds in escrow until the exchange is complete. This is important because you do not want to lose money and miss important deadlines which could cause you to pay a lot of money in taxes sooner rather than later.
Lastly, you need to tell the IRS about your transaction. This is done through Form 8824 with your tax return. On the form you will describe the properties, the timeline of when the properties were sold and bought, who was involved and also the money that was involved with the transaction. There are certain requirements that must be met for the properties you sell and the property you buy.
There are a few common ways to do a 1031 exchange in Florida. The different kinds of exchanges are:
· Delayed exchange;
· Reverse exchange;
· Simultaneous exchange; and
· Improvement exchange.
A delayed exchange is typically the most common 1031 exchange not only in Florida but throughout the country. In this 1031 exchange, you sell the property and then you purchase another property The timeframe for this exchange has a forty-five (45) day identification period, which gives the seller time to identify the property to buy, and then a one hundred eighty (180) day completion period, to complete the exchange.
The reverse exchange is essentially the opposite of a delayed exchange. The seller would first buy a replacement property and then sell the original property. This 1031 exchange is less common because it requires the seller to use their own cash up front to purchase the new property. For example, Igor sees that new plaza for $800K. Although he is trying to sell his current plaza, he is not getting any real interest. So, Igor decides to buy the new plaza first and was able to negotiate the price down to $700K in order to not miss the opportunity. In order for Igor to do a reverse 1031 exchange, he will need to sell his plaza within the required timeframe.
The next 1031 exchange is a simultaneous exchange. This 1031 exchange is very risky because the closings of both selling the property and buying the new property must happen at the same time. If there is even a slight delay, it can result in full taxation. For example, Igor found a buyer for his plaza and already has an offer on the new plaza. He was able to get a buyer for his plaza for $700K and he received an accepted offer for the new plaza for $700K with both closings to take place on September 1, 2022. If there are no delays and both properties close on September 1, 2022, then Igor will have completed a simultaneous 1031 exchange.
Lastly, the improvement exchange, or construction exchange, is a 1031 exchange that allows the seller to improve their replacement property with the profits from the original property. For example, Igor ended up finding a buyer for his plaza for double of what he paid for it, $1,000,000! He sold his plaza and bought the new plaza he has been eying for a long time for $750K. However, right before he closed in the new plaza, he discovered it needed more work than anticipated. Igor decided to use the profits from selling his old plaza and fix up the new plaza he just bought.
At the end of the day, when buying and selling investment properties, there are ways to avoid having to pay taxes upon the sale of investment properties, so long as the requirements are met and the timelines are strictly followed. Although Makris Legal, P.A. is a real estate and business law firm, we primarily do NOT issue tax advice. The information in this blog post is strictly informational and shall NOT be construed as legal advice. It is highly recommended to consult with a tax professional for tax advice.