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4 Types of 1031 Exchanges [Explained]

Understanding the 4 Types of 1031 Exchanges

The 1031 exchanges have long been one of the preferred tools successful real estate investors use to grow their investment portfolio while deferring costly capital gains tax. Today, we will look at the four types of 1031 exchanges, how they each work, and the nuances that could cost you dearly if they are missed.

Why Do a 1031 Exchange?

A 1031 exchange, named after the IRS code section it references, is a perk our government offers to incentivize investors to continue investing in more expensive assets. In this win-win scenario, investors can defer capital gains taxes when they sell a property and use all the proceeds to buy a more expensive one. The IRS agrees to wait patiently for you to sell any property you acquired by doing this, which has most likely increased in value and thus would net Uncle Sam more in collected tax.

Say you wanted to sell a single-family home you’ve owned for a few years and move that money over to a fourplex. If you had to sell the property traditionally, you’d be subject to paying up to 20% tax on any profit you made, leaving you with less money to invest in the fourplex. And mind you, that is if you held it for over a year. If you tried to sell it less than a year after buying, you’re looking at up to 37% tax, depending on your bracket.

 

Doing a 1031 would allow you to throw that money at your new purchase instead of taxes. The beautiful part is that there is no limit to how many 1031 exchanges you can do as long as you follow the strict guidelines set forth by the IRS.

The IRS has guidelines on timing and what is eligible to be exchanged. Since each of the 1031 exchange methods will have different timelines, let’s first review what is common to all types.

Standard Guidelines for All 1031 Exchanges

Only Assets Used for Business or Investment Can Be Exchanged

Your asset to exchange must be used for business or investment purposes. This means you cannot sell your residential real estate and exchange it for an investment property. There are other ways to avoid capital gains tax on your residence.

Exchanged Assets Must Be in the Same Asset Class

Your exchange cannot be for something outside of your asset class. If you sell real estate property, you cannot buy art or stocks with that money and avoid the tax. However, you can take advantage of other assets within your asset class, like duplexes, fourplexes, commercial property, and even land you intend to use for investment purposes.

Use a Qualified Intermediary

It’s essential to use a third-party Qualified Intermediary (QI) to handle all the funds in the transaction. Since the timelines for closing the properties may vary, there must be somewhere to keep that money until it is used on the next one. Your QI will ensure those funds are put into a particular escrow account until you are ready to close your next purchase. You cannot touch any of the money you receive from the sale. Doing so will invalidate your 1031 Exchange.

Beware of the Boot

Last but not least, to avoid paying taxes, you must use all the proceeds in your next purchase. Any money that you want to keep will be taxed as capital gains. Calculating your proceeds will take some help from your accountant. They would be the best person to give you your adjusted basis and any depreciation recapture numbers for the property you want to sell.

Nuances of Depreciation Recapture

Depreciation recapture can be a booby trap in your 1031 exchange. As you may know, taking a depreciation expense from your real estate investment against your taxable income yearly is a fantastic perk the IRS offers.

While it is super helpful in lowering your tax liability at filing time, just like capital gains, when you sell that property, the IRS will collect on anything not rolled over in a process called depreciation recapture. Depreciation recapture is taxed at a hefty 25%. So, how does this happen, and how do you avoid it?

Depreciation can only be taken against improvements. In the case of real estate, the improvements are any buildings on the raw land. You cannot depreciate against raw land. So, if you were to exchange it for raw land where you intend to rent it out as parking spaces or even farmland, all that depreciation you took on your relinquished property cannot be deferred to your new property since there is no building. You would have to pay that 25% tax on it. Please beware!

Alright, let’s move on to our four types of 1031 exchanges.

Delayed 1031 Exchange

Let’s start with the most common: a delayed 1031 Exchange. In this type of exchange, you sell your property first and then purchase your next one. You have 45 days from selling your property to identify up to 3 possible replacements and 180 days to close.

Both timelines start at the close of your purchased property. You do not get 45, followed by another 180. Your intermediary handles the identification of your properties in writing. You are stuck with your choice when you turn in that identification form. So, choose wisely and carefully.

With the strict timelines of 1031s, a successful 1031 starts with a realtor who is well-versed in real estate investing and 1031 exchanges. A lot of preparation will be needed to get the property ready for sale, manage that transaction, and coordinate the purchase of your replacement property, all within the strict timelines dictated by the IRS.

Every real estate transaction has obstacles. However, investment properties will have even more to contend with. Introducing tenants, property managers, and potentially other investors could impact your timeline for a successful closing.

Will tenants be willing to cooperate with any pre-listing repairs or scheduled showings and open houses? When under contract, will they make the home available for third-party inspections, repairs, and appraisals?

Uncooperative tenants can certainly stall any progress in buying or selling a property. Choosing to sell your property vacant would mean preceding any income until it sells, chipping away at the amount you will have to reinvest in your next property.

On the flip side, with investment properties, you might have another investor as your buyer. If that buyer has cash or is doing their 1031, watch out! You might be in for a swift close, accelerating your timeline to identify your properties.

In practice, you want assurance that your property will make it to the closing table before you start your identification process. This means getting past any inspections and, if your buyer is financing, getting through the appraisal as well. This could put you somewhere between 2 and 3 weeks into your transaction. If there is an issue with either of these, this could delay you into the fourth week, provided you were doing a 30-day close.

However, successful identification in just 45 days can be difficult in competitive markets with limited inventory. It takes time to properly vet a new purchase that must meet a reasonable investor’s criteria. There are financing considerations, as well as other property requirements like the building’s condition, location, and the potential for a good return on your investment. Finding one property that checks all your boxes can be challenging, let alone finding three.

Most of the time, your realtor would show you listings you are interested in right after listing your property. However, be careful when identifying too early. Any setback could elongate your escrow and, thus, your ability to purchase anything you already identified.

In tight markets, the likelihood of a property getting sold quickly, leaving you nothing to choose from, can be risky. But if you made an offer before your sale is considered a done deal, you need to consider the implications for that seller should yours fall out of escrow, resetting your closing timelines. Will that seller be willing to wait for yours to sell?

Remember, in this exchange, you must sell yours first before you can buy. If you have other financing options, let’s talk about a Reverse 1031 Exchange in a minute as a possibility for you.

Fortunately, IRS guidelines make some allowances you can use in these complex markets. The traditional way of identifying your properties is by listing up to 3 replacement properties, effectively giving you three options to make this work. Depending on the value of the identified properties and how much you have to invest, you can buy one, two, or even all three.

In these fast-moving markets, you might get antsy, especially if you are exchanging for quick-moving single-family homes or harder-to-come-by residential income properties. In the single-family scenario, you are competing with other investors and homeowners. With a residential income, there are fewer of these to choose from, and you will face more obstacles in terms of more tenants, a property manager, and even HOA bylaws in cases of some fourplexes.

200% Rule

You can mitigate some of this anxiety by using the 200% Rule, which allows you to identify more than three properties. The rule states that the combined fair market value of the properties cannot exceed 200% of the fair market value of the relinquished property. If you sell a property worth $500,000, the value of whatever you identify cannot be more than $1M.

Aside from allowing you more than three properties to choose from, investors commonly use this rule to diversify their portfolios. In the scenario above, you could identify a $50k parcel of land, a $300k duplex, a $150k condo, and a $500k fourplex, giving you better chances of making your 1031 work by mixing and matching your purchases.

Exception to 200% Rule: 95% Rule

As with anything government-related, there are exceptions to any rule. The exception to the 200% rule is the 95% rule. This rule states that you can identify unlimited replacement properties exceeding 200% of fair market value.

Still, if you do, you must purchase at least 95% of the fair market value of the properties identified. Exercising this option can be risky if you don’t have the money or financing to cover 95% of whatever you identify. This rule is not very commonly used.

Simultaneous 1031 Exchange

Interestingly enough, all 1031 exchanges were closed simultaneously in the olden days. Two investors would swap properties, closing both properties at the same time. This is less practiced for a couple of reasons.

Nuance number one: Finding two investors with similar investment goals, property types, and values can be complex. That is a lot of moving parts just to start. Then, both properties must have matching equity and debt to avoid one party is considered to have “boot.” Yet if all the stars align, Simultaneous 1031s are still a viable option the IRS offers.

Nuance number two: Your proceeds calculation must also account for any debt. If you sell a $500,000 property with $200,000 of debt and buy a $500,000 property with only $100,000 of debt, the IRS considers that difference of $100,000 “Mortgage boot”, and it is taxable.

Improvement 1031 Exchange

The Improvement Exchange, or Build to Suit, could be a perfect tool in your toolbox, especially when pickings are slim. An improvement exchange occurs when you find a replacement property that isn’t quite “like-kind” in value but could get there with the right improvements. It would allow you 180 days to make improvements to qualify the property as “like-kind” and enable you to defer any capital gains taxes on your acquisition.

A great example would be a run-down fourplex in a great location for $450k. If you had $500k, this property might not qualify. But if you used the remaining $50k to upgrade the property to a value of $500k or more, you could successfully close on that deal and not pay any capital gains tax.

As with any good deal, some requirements need to be met:

  • Any construction on the replacement property must follow specific guidelines in the purchase contract.
  • No fixing on the fly.
  • The exchanger must approve construction improvements to the property before funds are dispersed.
  • The exchanger specifies the alterations and improvements to the replacement property.
  • Only improvements to the replacement property completed within the 180-day timeframe will count towards the property’s value, and you may have a taxable event.
  • Replacement property improvements must be made to standing structures on the property and completed before the 180-day period ends.

You could use the funds to build a new building, but it must be completed within 180 days.

If planned carefully, you can do an improvement exchange in both a delayed and a reverse exchange. You must constantly communicate with your intermediary, realtor, contractor, and tax accountant to ensure all the numbers and timelines align so that you are not surprised by a tax liability. Remember, any ‘boot’ is taxable.

Reverse 1031 Exchanges

Our final type of 1031 is a Reverse Exchange. Arguably, this tends to be the most complex, with several moving parts to watch out for. A reverse 1031 exchange happens when you buy the replacement property and sell yours.

For example, a great deal you can’t pass up might fall in your lap. You might not have even been looking for a new investment, but now that it is there, you jump on it and get it under contract. Or you may live in an area where real estate is very cyclical, like Boise, Idaho. There is more real estate activity in the spring and early summer months, and listing at this time might increase your odds of selling your property quicker and possibly for a higher price.

The timelines remain the same as with a delayed exchange. You will have 45 days to identify which of your properties you want to sell and 180 days to close on selling that property.

Complexity of Reverse 1031 Exchanges

However, let’s look at why this type of exchange is more complex and less popular.

First, the IRS only allows you to simultaneously hold the title to one property. Instead, you must have your intermediary prepare an Exchange Accommodator Titleholder Agreement. This Exchange Accommodator Titleholder (EAT) will take title to either the property you purchase or the one you plan to sell.

Usually, an EAT is a single-member LLC whose sole purpose is to handle the ‘parked property’ for you while you complete your 1031. You are still responsible for loan payments, insurance, taxes, and operating expenses, but this will be handled through a triple net lease agreement that you will have with the EAT. All rent flows back to you as the exchanger.

Impact of Loan on Property

Whether you ‘park’ the new purchase or the one you plan to sell will be impacted by whether or not you have a loan on the property. Some lenders will take issue with the EAT being on the title. If there is a default, who is responsible? On the flip side, if you wanted to ‘park’ the one you identify to sell, would that change in ownership trigger the ‘due on sale’ clause part of many loan documents?

Transfer Taxes

Another factor can be the introduction of transfer taxes. Does your state charge a transfer tax when a property is changed to another name? If so, will they make exceptions when dealing with 1031 exchange transactions requiring an EAT? Idaho does not charge a transfer tax.

What If You Can't Sell in 180 Days?

What happens if you can’t sell your property within 180 days? At this point, you will have a failed 1031 and be subject to that pricey capital gains tax. Still, if you find that perfect property you have been eyeing for a while, having the right team in place can make a successful 1031 exchange a reality.

BONUS: Your Secret Weapon for Generational Wealth

I promised to share a secret that millionaires use to avoid paying the piper on any property that has been exchanged. How do families keep wealth through the generations? They leave those investments for their heirs to inherit when they pass away.

Example of Generational Wealth Building

Here is a scenario: You start with a humble single-family home you rent out when you outgrow it and move into a new one. After a while, you 1031 exchange that into a fourplex, deferring capital gains. Throughout your years as an investor, you grow your portfolio, reinvesting all your gains through 1031s into more significant and valuable assets. At the end of your life, you’re sitting on quite a tidy sum in terms of equity and deferred capital gains.

While Uncle Sam is licking his chops at the 20% of several hundred thousand gains he plans to collect when you sell off your properties, you can kindly give him the finger and keep those properties, letting them pass to your heirs, tax-free upon your death. Not only are deferred capital gains wholly wiped out, but anything inherited gets the bonus of a step-up basis. Everything in that portfolio is now inherited at total market value. If your children decided to sell those properties the day after you died, they would have no gain to report and zero tax liability.

In Conclusion

There you have it: the four ways to utilize 1031 exchanges to defer capital gains tax while improving your investment portfolio! Which one will you use?

Being a diligent investor requires time, energy, sacrifice, and many stressful days to build any successful investment portfolio. Because of that, I want to tell you about very important changes being proposed by the Biden administration regarding capital gains tax, step-up basis, and 1031 exchanges. If they go into effect, they will change how we build generational wealth. If you want to learn more about the proposed changes, please contact us directly!

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