What is a 1031 exchange?
A 1031 exchange allows an investor to sell their investment property and defer capital gains taxes as well as depreciation recapture taxes that would normally be triggered on their sale if they agree to use all of their sale proceeds to purchase one or more new properties of equal or greater value.
In total, taxes can be up to 40% of your real estate profits.
A 1031 exchange applies to any property that isn’t your primary residence and can even apply to primary residences if they have a home office, Airbnb use, or business use. There are several key rules and regulations that you need to know before you open an exchange.
Why should I do a 1031 exchange?
The wealthiest real estate investors I know all have the same strategy: buy and hold. You might hear stories of flippers making a couple of hundred grand a year, but trust me, the real wealth is generated with the buy and hold strategy.
As your portfolio grows, it becomes almost impossible to make as much as you could by paying down the principal on your mortgages and collecting rent. The more cash-flowing assets you can control, the better your portfolio will perform for you, and it will mitigate the risk of any one building not performing. Generally speaking, selling buildings only makes sense when the sale allows you to purchase more and grow your portfolio.
However, there is one strategy that experienced buy-and-hold investors use when they decide to sell that is usually the difference between whether selling a building makes financial sense.
This tool is the 1031 exchange.
Selling a building with the goal of using the capital to grow your portfolio can be very expensive, as you have to pay real estate commissions, inspections, title fees, bank fees, and, the most expensive fee of all, capital gains tax.
A 1031 exchange allows the savvy investor to sell their properties without paying capital gains, maximizing the amount of equity they can use to purchase a larger property, allowing the investor to accelerate the growth of their portfolio.
What properties qualify for a 1031 exchange?
Generally speaking, 1031 exchanges are strictly for a property that isn’t your primary residence. However, there are situations where a portion of your primary residence can be exchanged. You can exchange:
- Rental property
- Your former residence
- Vacation home or second home
- A portion of your primary residence if you have a home office or Airbnb
- Commercial property
You can also potentially qualify if you’re getting a divorce and moving out.
Make sure you speak with a qualified intermediary or other professional to confirm your property qualifies before starting an exchange.
How does a 1031 exchange work?
A 1031 exchange has to be done through a qualified intermediary who holds your proceeds from the sale of your home while you wait for your purchase to complete. They will also handle all of your paperwork.
A 1031 exchange is actually just a series of paperwork and identifications to properly document the properties you’re relinquishing and the new properties that you are exchanging for.
To start, you need to open an exchange with a qualified intermediary, and then list your property for sale. Once your property is for sale, you can begin to look for a replacement property that you will be exchanging for.
At closing for each property, there will be a series of paperwork that you will sign provided by your intermediary. In some instances, the intermediary will take the title on behalf of the investor, to properly facilitate the exchange.
1031 Identification Periods
1031 exchanges require the investor or trader to properly document the properties that they’re going to be purchasing through their exchange. There are two important rules to keep in mind when you’re searching for your replacement property.
- You must identify your replacement property within 45 days of the sale of your relinquished property.
- You have to close on your identified property within 180 days total.
The identification period creates significant risk, as a deal might fall apart after the initial 45-day period, and the investor could be forced to go through with a bad deal or pay taxes on their gain. However, certain reinvestment options are always available to investors and can be listed on your property identification form in case your other options fall through.
What kinds of property can you identify for a 1031 exchange?
There are three ways that you can identify property:
- Three-Property Rule: Identify up to three properties and close on at least one of them within 180 days.
- 200% Rule: This allows the investor to identify an unlimited number of properties, but the total property value can’t be more than 200% of what you sold your property for.
- 95% Closing Rule: This allows the investor to identify an unlimited number of properties as long as you end up purchasing 95% of them. This is rarely used and should be used with extreme caution, as one property not going through can stall your entire exchange.
Are there different kinds of 1031 exchanges?
There are six types of 1031 exchanges:
- A simultaneous exchange allows you to sell your property and buy a replacement at the same time.
- A delayed exchange is the most common exchange, where you sell your property and buy a replacement within 180 days.
- An improvement exchange lets an investor sell their property and use the proceeds to renovate and improve their new investment.
- A personal property exchange lets a homeowner exchange personal property, which is divided into a depreciable and non-depreciable property.
- A reverse exchange is the most complex, and it allows the investor to buy their new property first with their intermediary taking title, and then sell their replacement property within 180 days.
- A Delaware Statutory Trust (DST) exchange allows the investor to exchange their property for a fractional interest in a large professionally managed project, freeing them from their responsibilities as a landlord. This is the most common type of exchange for older landlords who no longer want the headaches of dealing with a rental property, but still, want the monthly income that rental property provides.
How much does a 1031 exchange cost?
The cost of a 1031 exchange can vary widely depending on who you use as your qualified intermediary, ranging from around $500 to several thousand dollars.
It’s important that you verify that whoever you choose to do your exchange is a qualified intermediary and has the experience necessary to properly complete your exchange.
Clever has partnered with Asset Preservation Incorporated to offer 1031 exchanges. API has over 29 years of experience, has done over 180,000 exchanges, and offers very competitive rates for every type of exchange.
Does it make sense to do a 1031 exchange?
A 1031 exchange is one of the most powerful tools a real estate investor has to preserve their equity and accumulate significant wealth in real estate.
However, doing an exchange isn’t always a good idea. 1031 forces the investor to buy a replacement property or replacement properties of equal or greater value. It’s common for the proceeds from a 1031 exchange to be used for the down payment while bank financing covers the rest of the new property. This exposes the investor to more liabilities and a greater monthly obligation.
Not all investors are in a position where they want to grow their portfolio, as they might have already reached their goals as an investor.
While the 1031 exchange is an incredible opportunity, you need to make sure it’s the right decision for you.
Risks of a 1031 Exchange
On paper, it’s hard to imagine how a 1031 exchange could be a bad thing. However, as any real estate investor can tell you, deals almost never go 100% according to the plan.
First, you have an identification risk. As discussed above, there are strict rules around identifying the property. If you identify a property and realize that you aren’t able to buy it after 45 days, you are no longer able to do your exchange.
Then you have market risk. If you sell your property and are facing a 45-day window, you might be inclined to put a property you wouldn’t normally buy under contract, just to avoid taxes. This can cause a normally conservative investor to overpay and make a bad purchase.
Finally, the biggest risk comes from other investors negotiating against you. If the other party know that you’re doing 1031 exchange, they can use that information against you. If the negotiation goes past the 45-day identification window, there is a very good chance they won’t be willing to negotiate much, as they know that you’re forced to either make the purchase or pay taxes. A great strategy you can use here is to not let the other party know that you’re doing a 1031 and only disclose once all contingencies have been removed from the contract.
Ready to start your 1031 exchange?
If you’re ready to open a 1031 exchange, Clever’s partnership with Asset Preservation Incorporated is a great place to start. With over 29 years of experience, 180,000+ successful exchanges, and hundreds of great reviews, your exchange will be in great hands. API also offers a letter of assurance from their parent company, Stewart Information Services Corporation (NYSE: STC)
Click here to start your exchange and schedule a free consultation.