As a real estate investor, you likely have contemplated selling property you currently own, but have held back in fear of paying a hefty tax bill. Although taxes are owed when you sell a property for a profit, participating in a 1031 exchange can help defer paying taxes on the sale over the course of your lifetime. There are several benefits in executing a 1031 exchange, but the IRS has implemented several rules and regulations investors must abide by to reap the tax benefits, making it fairly complex. In this article, we’ll discuss what a 1031 is, the rules investors must abide by, how President Biden’s new tax plan may impact 1031 exchanges, and how participating in an exchange can help you save a significant amount of capital. We’ll also discuss Qualified Intermediaries, who are the individuals responsible for facilitating a transaction.
If you want to step away from the hassle of being a landlord altogether, you can also do a 1031 exchange into multifamily syndication, which often provides higher cash flow and a better return on investment. We have helped many of our clients do a 1031 into multifamily syndication and would be happy to help you. Contact us to get started.
What is a 1031 Exchange?
A 1031 exchange is a tax code that allows real estate investors to defer paying capital gains tax when they sell a property. To do so, the investor must reinvest the proceeds from the sale of the property into a “like-kind” property. Because the investor is keeping the funds in real estate and does not earn profit on the sale of the property, there isn’t any income for the IRS to tax. There is no limit to the number of 1031 exchanges an investor can participate in, meaning investors can defer capital gains tax over the course of their lifetime.
Rules for a 1031 Exchange:
1. Property Must be “Like-Kind”
If an investor seeks to execute a 1031 exchange, they must sell their current income-producing property and exchange it for a “like-kind” property, meaning it must be used for productive use in a business, trade, or investment. The property cannot be the investor’s personal residence, it must be an income-producing property.
Here’s the good news: “like-kind” property is not quite as restrictive as it sounds. Investors can choose from office space, apartment buildings, retail shopping centers, industrial parks, multifamily buildings, and other income-producing properties. This offers investors the opportunity to experience owning a wider range of property types to diversify their portfolio.
2. 45-Day Identification Period & 180-Day Closing Period
One of the greatest challenges that comes with executing a 1031 exchange involves the limited time the investor has to facilitate the transaction. After an investor decides that they want to execute a 1031 exchange, they have only 45 days to identify the property (or properties) they wish to purchase.
Up to three properties can be identified for reinvestment. This is typically advised, as the additional two properties act as a reserve in the event your first choice fails to close. Alternatively, you can purchase all three properties as part of the 1031 exchange. If you choose to target more than three properties, the aggregate value of the properties cannot exceed 200% of the value of the property you’re
After identifying the property/properties you wish to purchase, you then have 180 days to close. The properties can be of lesser value than the property you’re selling, but you will have to pay capital gains tax on the difference. For example, if you’re selling a property for $15,000,000 and reinvesting the proceeds into a building for $10,000,000, you will have to pay capital gains on the $5,000,000 difference. Knowing that, it is typically encouraged to reinvest into properties that are of equal or greater value to avoid capital gains tax altogether.
Additionally, if you choose to defer taxes by reinvesting the proceeds into one, two, or three properties, you don’t have to close on all of the properties within the 180-day time period. As long as one or two of the properties is of equal or greater value than the property you’re selling, you can close on those properties within the 180-day window and close on the third property at a later date. If you choose to move forward with more than three properties, you must close on at least 95% of the combined value of the identified properties within the 180-day closing period.
3. You Must Hire a Qualified Intermediary
As the investor, you are prohibited from accessing the funds that are being transferred into the 1031 exchange. Instead, you must hire a Qualified Intermediary, who is the individual responsible for holding the funds and guiding the transaction process. In addition to helping you meet your deadlines and holding the funds, Qualified Intermediaries also ensure you comply with all IRS guidelines throughout the process.
Will President Biden’s New Tax Laws Eliminate the 1031 Exchange Program?
Answers are not available on this yet. The Biden administration has created a policy proposal titled, “The Biden Plan for Mobilizing American Talent and Heart to Create a 21st Century Caregiving and Education Workforce.” While it has not been specifically stated that 1031 exchanges will be included in this policy, it will be paid for by “rolling back unproductive and unequal tax breaks for real estate investors with incomes over $400,000.” Knowing this, it is possible that the 1031 exchange will be included in this policy proposal, but we aren’t entirely sure yet. We will not know for sure until the policy is rolled out.
The 1031 exchange can be a valuable tool for real estate investors seeking to defer taxes and keep their funds in the real estate market. As a result of the rules, regulations, and nuances involved in a 1031 exchange, it is strongly encouraged to consult with a tax professional to ensure the exchange is executed properly.
Here at Mentis Capital Partners, many of our investors are in the process of selling their properties and seek to execute a 1031 exchange. If you are interested in doing a 1031 exchange into multifamily syndication, we can help you get started. Click here to send us a message and we would be happy to help.