- commercial real estate
- investing strategy
- real estate
- real estate investing
- tax avoidance
- tax hacks
- tax mitigation
- tax strategy
This infographic covers the basics of the 1031 exchange. The 1031 exchange allows an investor to defer the capital gains taxes that would otherwise be due on the sale of investment property.
In a traditional sale, capital gains taxes can exceed 20-30% (you can calculate your capital gains taxes here). However if the proceeds from the sale are reinvested according to the rules in section 1031 of the Internal Revenue Code, those taxes can be deferred.
In order to complete a successful 1031 exchange, an investor must not take “constructive receipt” of the proceeds from the sale of the relinquished property. If an investor were to receive any money such as a wire from escrow to their bank account or even an uncashed check with the closing proceeds, this capital would become irreversibly taxable. To avoiding taking constructive receipt of the proceeds during a 1031 exchange, it is imperative that an investor have a Qualified Intermediary (“QI”) hold the capital during the period between the sale of the relinquished property and the acquisition of the replacement property (you can read more about choosing a Qualified Intermediary here).
To complete a 1031 exchange, an investor must follow three rules. First, the replacement property must be like-kind to the relinquished property. Generally, real estate held for business or investment purposes in the U.S. or U.S. Virgin Islands is considered “like kind,” including commercial and residential property (you can read more about 1031 property identification here).
Second, the total value of the replacement property must be equal to or greater than the total value of the relinquished property. Capital that is not reinvested is taxable (“boot”).
Lastly, the ownership title for the replacement property must be identical to the title for the relinquished property.
Additionally, there are strict time limits for the identification and acquisition of the replacement property. Once escrow is closed on the relinquished property, the investor has 45 calendar days to identify potential replacement property, and 180 total days to acquire the replacement property (you can calculate your 45/180 day deadlines here).
The identification of potential replacements has to follow one of three rules. An investor may identify up to three replacement properties and purchase any of them, regardless of their total value, to complete the exchange (“3-Property Rule”).
Or an investor may identify more than three replacement properties, if their total value does not exceed 200% of the value of the relinquished property. The investor may purchase as many of the identified properties as desired (“200% Rule”).
Finally, an investor may identify any number of replacement properties, regardless of their total value, as long as the investor acquires 95% of the total value of all of the properties identified (“95% Rule”).
If an investor wills an investment property to his or her heirs, the basis by which the capital gains are determined steps up to the current market value.