What is a 1031 - Do's and Don'ts of a 1031 Exchange
As the springtime approaches, more and more homes come on the market. For some, people who want to become investors or who are already investors may want to buy or sell properties. Some investors use a 1031 exchange. a 1031 exchange can be a great way to buy or sell an investment property.
I am a local Salt Lake City here to assist you. I have personal experience working with 1031 exchanges.
What is a 1031 property exchange?
The term 1031 exchange comes from the section of the IRS tax code that deals with like-kind exchanges. A 1031 exchange can also be known as a like-kind exchange, as referred to in the tax code, or a Starker exchange, based on the name of the lawsuit that first identified the exchanges as legal. A like-kind exchange means that you are exchanging business or investment property for business or investment property. You can no longer exchange valuables like art or jewelry. The properties you are exchanging do not have to be the same types of property, but they do have to be properties used for investment or commercial purposes.
You cannot apply the 1031 exchange to personal property, like your primary residence. You can, however, exchange a large real estate holding like a farm, apartment complex, or luxury rental home for several smaller properties if the combined cost of the new properties is the same or greater as the cost of your original property. Other details of a like-kind exchange are listed below. Many investors may use an exchange to swap properties from one state to another because they can move up or get more smaller properties. For example, some investors, will sell their property in California and buy either a multi-unit property, an Airbnb, or a few single-family homes.
1031 exchange has a set of rules the buyer must follow:
It is recommended to use a qualified intermediary to handle the transactions. If you choose to work with a 1031 Exchange Company, be sure they are insured to protect your money from disappearing in escrow. I have one particular that I have worked with for years, so I trust them. I think you can also use a title company. I would check. The intermediary company acts as a second escrow company. So, it is best to set up the information as the client is in escrow with one property and starts the hunt with the next one.
The buyer has 45 days after the sale of one property to identify a minimum of 3 properties the next property you will be purchasing. You may present 3 different properties, but you must end up closing on one of them.
You must close on one of those property within 180 days No extensions will be granted.
I have heard the property cannot be sold for two years, but I would double check with a CPA. Realtors ARE NOT allowed to give any tax advice. You as the buyer, needs to check and satisfy all that Information yourself.
Why do a 1031 exchange?
So why do people engage in 1031 property exchanges? According to Realty Mogul, there are several reasons as to why people use a 1031 Property Exchange. The number one reason is to defer taxes. After all, who isn’t looking for a way to reduce their tax bill? People also use the 1031 in estate planning, so their heirs don’t get hit with a huge tax bill. Sometimes real estate investors want to exchange a property that has maxed out its depreciation for a property with additional depreciation. Perhaps the property isn’t producing as much revenue or appreciating as quickly as the owner would like.
Real estate is all about location. With an eye toward the future, an investor might exchange a property in an area that is losing property value for a property in an area where property values are increasing. If investors move a distance away from their investment properties, it makes sense for them to use a 1031 Exchange to purchase new properties closer to home. Sometimes the reason for the exchange is simply that the investor finds a property he/she likes better. I can tell you that I have done at least 6 personal exchanges. Most recently a few years ago, one of my investment properties had a lot of plumbing issues and with it being a short-term rental in the midst of COVID in an resort area, I was afraid of losing money.
What can a 1031 exchange be used for?
1031 property exchanges are only valid for investment and commercial properties. An investor may be looking to diversify his/her investments, for example, selling a strip mall and buying an apartment building, a rental condo, and a small business location. Other real estate investors want to consolidate their investments, so they trade several small properties for one large property. A 1031 property exchange is also used to maximize the multiplication and leverage potential for an investor. And some folks are just ready to trade co-ownership for single ownership. Whatever the reason, many real estate investors are finding 1031 exchanges help them maximize their return on investment.
Using a like-kind exchange can help investors grow their investments tax-deferred for as long as they like. Let’s say you decide to invest in a rental condo when you are fresh out of college. If you continue to exchange up – one condo turns into two turns into a single-family home, etc. – by the time you reach retirement, you will have built up a revenue stream that can help support you in retirement. If you hire others to manage your properties, you’ll have that income without having to do much work.
There is no limit to the number of exchanges you can make. If you decide to sell your investment properties at some point, you will be taxed at the long-term capital gain rate, which is about 15%-20%. If your investment property becomes part of your estate, it is adjusted to its current value upon your demise, so your investors will not have to pay the long-term capital gains tax. However, if your off-spring are following in your shoes as property investors, they can keep delaying the capital gains taxes as long as they keep selling and purchasing property.
Can you use a 1031 exchange property for personal use?
What if you want to use a like-kind exchange for a ski Airbnb that they rent out? Heck – we are in Utah. You’ll probably want to enjoy it as well. You can make this work, but I strongly recommend talking with your CPA again, because you will need to be very careful about following the rules. I think it’s personal use of the property cannot exceed 14 days or 10% of fair rental days, whichever is less.
You also must rent the home for at least 6 months out of the year in an official capacity, meaning you are charging a fair rental fee, and you have renters. You also must show proof on your taxes.
If you are buying from a seller that is doing a 1031 exchange, please understand that it does not affect your buyers at all. There is no cost involved at all with the buyers. However, the buyers do need to understand and acknowledge that the sellers are doing a 1031 exchange.
In summary, real estate is known to be a good investment because people are always going to need a place to live. Utah has a strong rental market because people are moving here and need a place to live. It is a great place to invest because our outdoor lifestyle. So, if you have any other questions about 1031s, please reach out to me, Nancy Bergman at Salt Lake Home Pros / Fathom Realty or your tax advisor.
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