For anyone new to the world of real estate investing, you’ve likely heard of something called an IRS 1031 exchange. But, most people I speak to avoid it altogether because it seems complex on the surface. You’ll hear people say things like, “it’s too complicated,” or “it’s too risky.” For those reasons, I’ve prepared the IRS 1031 Exchange for Newbies Guide.
Over the past 23 years, I’ve been helping real estate investors successfully complete their 1031 exchanges. As a 1031 exchange specialist, I’m with my clients every step of the process, from helping select the qualified intermediary to the identification process, to closing on the replacement property.
My specialization is in triple net lease, fractional ownership, and institutional-quality properties under full-time professional management. All the different real estate asset classes are available. Let’s talk about what a 1031 exchange is and why it exists.
Established in Section 1031 of the IRC , it was created to allow real estate investors to defer paying capital gains taxes when they sell an investment property and reinvest the proceeds into a “like-kind property.” However, as the code makes clear, most real properties are like-kind, and the seller of a business property can successfully defer the coming of the tax man.
Think of it this way: with this strategy in play, the fruits of your labor stay yours to cultivate, driving your financial success forward. Instead of giving a chunk to Uncle Sam, you get to use that money to acquire property or buy an even bigger or better property.
Table of Contents:
- Why Would I Want to do an IRS 1031 Exchange?
- What Type Of Properties Qualify For An IRS 1031 Exchange?
- What About Those “Delaware Statutory Trusts” I Keep Hearing About?
- What Exactly is Depreciation Recapture?
- Important 1031 Exchange Rules And Deadlines You Need to Know About
- How to Navigate the 1031 Exchange Process Effectively: Tips for Newbies
- Reporting Your Exchange
- Common Pitfalls and How To Avoid Them
- Final Thoughts on IRS 1031 Exchange for Newbies
- Conclusion
Why Would I Want to do an IRS 1031 Exchange?
There are many advantages to doing a 1031 exchange. For instance, think about a scenario where you own an apartment building and you’re tired of being a landlord.
But, you also don’t want to lose a significant portion of your profits to taxes when you sell. You can use a 1031 exchange to swap that apartment building for, say, a triple net lease retail center.
If you opt for this strategy, two nice benefits come your way: more income and no immediate capital gains tax bill.
What Type Of Properties Qualify For An IRS 1031 Exchange?
The term “like-kind” confuses some folks new to the world of 1031 exchanges. It doesn’t mean you need to find another property nearly identical to what you’re selling. According to the IRS , properties that qualify for a 1031 exchange must be “like-kind”, which has a flexible definition.
The main rule is that you’re trading one investment property for another investment property. The IRS 1031 exchange rules apply to many asset classes, like:
- Multifamily properties.
- Single-family homes.
- Self Storage.
- Undeveloped land.
- US Government Buildings.
- Medical buildings.
- Industrial properties.
- But wait, there’s still more to discover – hidden gems and surprises.
I always tell investors new to 1031 exchanges to focus on these things, especially if you’re brand new to real estate investing:
- Don’t let the complexities of depreciation recapture scare you out of pursuing other real estate.
- Consider talking to an experienced 1031 specialist to answer your questions and alleviate your fears about taking the first step.
- Don’t disqualify yourself (or allow someone else to disqualify you) because you might not understand everything about how 1031 exchanges work.
What About Those “Delaware Statutory Trusts” I Keep Hearing About?
For many investors, Delaware Statutory Trusts (DSTs) represent one of the easiest paths to 1031 exchange benefits. Through these trusts, the average investor gains entry to a world of top-tier real estate assets – the same ones institutional investors count on. This can be done at relatively lower investment minimums, which makes for a perfect IRS 1031 exchange for newbie transactions.
They’re not limited to one type of property – their portfolios can include everything from hotels to warehouses. In many instances, you can participate in DSTs on a passive basis too.
What Exactly is Depreciation Recapture?
Real estate investors can depreciate the value of their rental properties as a tax benefit to offset income. But, the catch with depreciation is, it needs to be recaptured at a later date. You can think of it like a loan on taxes, interest-free.
Typically, the rate for depreciation recapture tax is 25%.
Let’s consider an investor who purchased a rental property some time ago. They’ve claimed $100,000 in depreciation over time. Later down the road, they go to sell the property for a sizable gain.
Assuming a depreciation recapture tax of 25% applies, they would need to pay the IRS $25,000 from that depreciation.
Important 1031 Exchange Rules And Deadlines You Need to Know About
While you’re probably excited to put your first or next 1031 exchange together, the government imposes some stringent guidelines you’ll need to follow. One critical one involves timelines.
Here’s a breakdown of the most common timelines that impact almost all investors utilizing the benefits of this section of the IRS tax code.
| Deadline | Time Period | Details |
|---|---|---|
| Identification Period | 45 Days | Investors have exactly 45 days beginning the day after the sale of their “relinquished property” to identify potential replacement properties. These need to be relayed in writing to the investor’s qualified intermediary. And, while up to three properties can be identified without regard to cost, those wanting to identify more than three replacements fall under what’s known as the 200% rule. The investor has a maximum of 180 days, starting from the sale date of their original property. For example, if an investor is identifying their next replacement property exactly 45 days later, they’ll only have 135 days remaining to complete the 1031 exchange process. |
| Exchange Period | 180 Days | Investors have a total of 180 calendar days, including weekends and holidays, to close on their chosen “replacement property.” If the 180th day falls on a weekend or holiday, the deadline isn’t extended. No extensions to these deadlines are granted, no matter the circumstance, including acts of god or title issues with the property. Should you not complete the 1031 exchange within the specified time periods, the IRS may consider the exchange invalid, triggering those taxes you were trying to avoid in the first place. |
How to Navigate the 1031 Exchange Process Effectively: Tips for Newbies
As one of the most seasoned 1031 exchange specialists in the country, I put together this quick guide for anyone unfamiliar with how a like-kind exchange works. Here are a few of the important aspects I cover with almost all of my clients:
Selecting A Qualified Intermediary (QI)
A qualified intermediary, commonly referred to as a QI, is an essential part of any 1031 exchange. Look for someone with battle scars from navigating tricky exchanges and a razor-sharp understanding of the latest tax regulations – their market rep should shine like a beacon. Make sure to select a qualified intermediary who is financially sound and holds the exchange funds in a segregated bank account.
Start Your Search for a Replacement Property
Now, the fun begins. This step in the process is often what my investor clients are most surprised with. There’s a reason you’re wondering why – what’s behind your curiosity? According to the IRS , properties that qualify for a 1031 exchange must be “like-kind,” which has a flexible definition.
But you want to be extra diligent, especially since you have a limited timeframe to identify potential replacement properties. Some crucial aspects you want to pay close attention to include conducting a complete financial analysis, securing your financing early in the process (if using any leverage at all), and completing your due diligence within the specified timeframe.
Closing On Your Replacement Property
Congrats, you’re now in the final steps to ensure you meet all the IRS requirements for a 1031 exchange. Just make sure you meet those deadlines referenced in the table I provided.
Ensure the deed is properly titled in the same name or entity as the relinquished property. Next, carefully sift through each document to root out any errors, confirms they’re error-free and meet all necessary regulatory standards. Keep in mind each property acquired must meet these requirements.
Reporting Your Exchange
It’s also vitally important to report your 1031 exchange transaction, as required by law. Follow these steps to get it right – I’ve laid out a clear roadmap to guide you.
Filing Form 8824 with Your Taxes
After the sale, you would report the 1031 exchange by filing Form 8824 with your income tax return. You’ll want to have all documentation easily accessible.
This includes all records pertaining to the exchange, including sales contracts, closing statements, identification notices, exchange agreements, and of course, those deadlines and the steps you took throughout the transaction to properly adhere to them. The IRS often performs audits to ensure you’re in full compliance with Section 1031 rules.
Common Pitfalls and How To Avoid Them
It’s critically important to learn from other investors’ mistakes. This will keep your transaction in check.
Receiving Funds Directly
Don’t touch that money. The IRS disqualifies transactions when the investor (or a related party) receives any funds from their exchange. The transaction must flow through a qualified intermediary (QI) to adhere to all IRS rules and deadlines.
Not Reinvesting the Entire Amount of Your Capital Gains
You want to defer 100% of the capital gains? You need to reinvest the total capital gains. Forward-thinking individuals will appreciate how this tactic can carve out a smaller tax burden in the years to come.
Any uninvested proceeds will be taxable.
Final Thoughts on IRS 1031 Exchange for Newbies
Many find it surprising how much they’ve reduced their tax burdens while expanding their portfolios into asset classes. DSTs help accomplish that easily since institutional-quality real estate is hard to acquire, especially if you’re new to the space. Remember to follow those IRS rules.
Conclusion
I hope this beginner’s guide on IRS 1031 exchanges was helpful for you. Top-tier strategies at your disposal. It helps investors expand their portfolios tax-deferred. With some understanding of the IRS rules and a seasoned professional in your corner, you’ll be amazed at the doors an IRS 1031 exchange opens.