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Rachel Bevill-Cottrell | 2022-07-08

How Does A 1031 Exchange Work?

How Does A 1031 Exchange Work?

If you’ve found yourself in a situation where you sold one investment property and you’re looking to reinvest in a new property, you may have heard mention of a 1031 exchange. But what exactly is a 1031 exchange? Sounds intricate, right?

While initial stages of research can be overwhelming, fear not! We have done our due diligence, and this article will give you a clearer understanding of 1031s and what to expect.

What is a 1031 Exchange?

A 1031 exchange is derived from section 1031 of the Internal Revenue Code. Essentially, it’s a way to exchange one real estate investment property for another to defer paying the capital gains taxes on the sale of the initial property.

When you sell a piece of real property that has appreciated in value, you will likely owe taxes on the associated capital gain, or in layman’s terms, the profit made on that particular sale of real property.

With a 1031 tax-deferred exchange, you’re able to re-invest that capital into a new investment property, and in doing so, postpone paying the capital gains tax.

In some 1031 exchanges, the seller may be interested in exchanging their depreciable property in an attempt to achieve depreciation recapture. This is essentially an exchange of improved land for unimproved land. The goal in this type of transaction is typically that the depreciation on the improved land would be considered “recaptured” and taxed as regular income.

Each 1031 exchange is unique, and there are several details that need to be considered when approaching this venture. Feel free to use this checklist as a guide to understanding why a 1031 exchange might be right for you:

  • What are the benefits of a 1031 exchange?
  • Do you qualify for a 1031 exchange?
  • Is the exchange like-kind?
  • How much time do you have?
  • What are considered tangible and intangible assets?

What are the Benefits of a 1031 Exchange?

You might be asking yourself, “How can I defer capital gains taxes when selling land?”

While swapping land may appear to be a pointless transaction without larger context, a 1031 exchange actually provides the landowner with an opportunity to capitalize on the appreciation of the first investment property and reinvest the larger amount (the gain that they are deferring paying taxes on) into a property that could have a higher return.

Some investors even choose to add more capital from their personal finances to the capital from the original sale and invest in a property that exceeds the value of the original investment to increase the size of the real property purchased and the value of the potential return.

This can be done over and over again, continually purchasing larger and larger tracts of real estate, because there is not a limit on how many times a single person or entity can complete a 1031 exchange.

Do you qualify for a 1031 exchange?

To qualify for a 1031 exchange, the property you’re selling must be an investment property, business property, or otherwise be held for a productive trade. There are many property types that could qualify for a 1031 tax-deferred exchange.

Maybe a simpler way to determine whether your property qualifies for a 1031 exchange is to establish whether you’re using that property for personal use. Properties held for personal use do not qualify for a 1031 exchange as they are not considered investments.

Because the regulations are so broad, and there are multiple unique situations that may warrant a 1031 exchange, it is important to consult with a specialized land agent, a trusted tax and/or legal advisor and a qualified intermediary before beginning the process of a 1031 exchange.

What is considered a like-kind exchange investment?

A like-kind property is not indicative of the quality or grade of the property, meaning you could exchange one type of investment property for another (i.e. a vacant lot for a commercial building) so long as the new property acquired is of equal or greater value to the original investment property. However, whatever exchange you choose to do, the new property must be held as an investment for a certain period of time and not purchased with the intent of personal use or rapid resell.

How much time do you have?

Understanding time restrictions is another crucial step in beginning a 1031 exchange. Once you sell your property, you are required to reinvest that capital within a certain timeframe.

After closing on the first property sale, you have 45 days to identify a new investment property and 180 days (from the time of close on the original property) to close on the new property.

While certain federally declared disasters (such as the Coronavirus Pandemic) may qualify a 1031 exchange timeline for an extension, following these deadlines closely will allow the exchange to flow seamlessly, and failure to do so can derail the entire transaction.

What are considered tangible and intangible assets?

1031 tax deferred exchanges have to be made with tangible assets. Because you do not have to recognize a gain or a loss when you exchange a property via a 1031 exchange, it is pivotal that you understand what is considered tangible and what is considered intangible.

Tangible assets are real properties, and intangible assets are anything that falls outside of the regulations of a 1031 exchange. For example, personal property and items (like machinery) are considered intangible assets and must be recognized as a gain.

In other words, you would likely need to pay taxes on all personal property involved in a 1031 exchange.

How To Start a 1031 Exchange

Securing a qualified intermediary is another crucial step in beginning the process of a 1031 exchange.

A qualified intermediary must not have any previous relationship with either party involved in the property exchange, and their job is to secure and hold the funds at the time of the initial land sale, and then transfer those funds when a property for reinvestment is purchased.

Next Steps in a 1031 Exchange

If you’re already seeking out a new property, it can be a hassle to discern what type of real estate you’re allowed to make the exchange on. A good rule of thumb is to make sure it checks two boxes:

  • Is it like-kind?
  • Is it of equal or greater value?

*The property that you plan to reinvest in must be of like-kind and be of either equal or greater value.*

A tax and/or legal advisor can help you determine what type of real estate you’re allowed to make an exchange on, but it’s important to know that the Internal Revenue Code prevents landowners from reinvesting in a cheaper property and pocketing the remaining capital.

Final Thoughts on a 1031 Exchange to Land

Traditionally, a 1031 exchange was an exchange between two individuals that wanted to essentially swap properties. A starker exchange, or a delayed exchange, is what many people do now and is commonly referred to as a 1031 tax deferred exchange.

The simplest way to look at a 1031 exchange is as an investment opportunity that will allow you to defer paying a capital gains tax.

While you’re not entirely avoiding paying the capital gains taxes, you are able to defer paying them with each new investment instead of paying them over and over again. It also grants you extra capital to continually re-invest larger sums of money so that you can potentially appreciate a higher return on the new property.

If you’re considering a 1031 tax deferred exchange, our agents can help you identify a new property and connect you with the right advisors to help you complete the process!

Please note: this article is meant to be a topical overview and, as such, does not include specific financial, legal or professional recommendations or advice. Every situation is unique, and you should consult with a licensed attorney, accountant, and/or financial advisor prior to entering into any written contract or verbal agreement involving a 1031 exchange.