1031 Like-Kind Exchange
(Please refer to the diagram as we explain the fundamentals of this tactic.)
1031 Exchange, also known as “Like-Kind Exchange” is a tax strategy used by real estate investors to defer Capital Gains taxes into the future, which would normally be owed at the time of a sale.
Let’s assume the owner of a rental property sells the property, but wishes to remain invested in real estate, but does not want to pay capital gains taxes which would normally be due upon cashing out an investment property.
The owner could defer the tax liability by:
- Sell the original property. (“Disposition”)
- Identify one or more properties within the “Identification Period” of 45 days from the Disposition date; of which, one or more must end up being the Replacement Property(ies).
- Within 180 days of the Disposition, acquire the Replacement Property(ies).
There are numerous advantages and disadvantages of a 1031 Exchange:
Advantages of a 1031 Exchange
Defer Capital Gains, for years, or potentially for the Investor’s entire life. (Yes, their estate would end up paying those deferred Capital Gains taxes.)
Allow the Investor to pull a large amount of cash/equity from a property, tax-free, and use it to buy multiple properties. If mortgages are used on the Replacement properties, it can allow the Investor to spread that equity cash around and thereby “leverage” it to gain multiples of appreciation through now owning several investment properties.
Disadvantages/Caveats of a 1031 Exchange
Electing to utilize a 1031 Like-Kind Exchange instead of paying the capital gains taxes resulting from the property sale, would certainly seem vastly appealing to most tax payers. However, there are landmines in this tax strategy which all owner/investors must be aware. The most obvious disadvantage is keeping the investor’s money tied up for an ongoing, lengthy period of time when the investor may have other needs for their cash.
Another hurdle of the process is being sure to consummate the purchase of the Replacement property(ies). While 180 days may seem like plenty of time, as you are sitting in your easy-chair reading this, it actually can pass very quickly. If you have been involved in any real estate deals, you certainly understand the complexities of finding, negotiating, securing financing, dealing with contingencies, and finally closing on a property. And multiply those tasks if you elect to replace the original property with multiple replacement properties. Not only can a ticking clock put stress on us, it is a major disadvantage in the world of negotiating a deal. “He who controls the Clock, controls the Deal” is a mantra which we have come to understand over the years we have been in practice.
However, the largest Caveat to utilizing a 1031 Exchange is the 45 day Identification Period. 45 days is a very, very short period of time to do all the tasks required in being able to accurately identify a list of potential properties, of which at least one of those properties will actually be the Replacement property. So in reality, that Ticking Clock just dropped from 180 days down to 1 ½ months. Now instead of a gun to your head, you have a cannon.
Instead of a traditional 1031 Exchange with the steps just described, you may want to consider the following option:
1031 Exchange option…A Reverse 1031 Exchange
Briefly stated, a Reverse 1031 is when the investor buys the Replacement property BEFORE selling the Original property, then sells the Original property. The same deadlines still apply, but can shift the time pressures a bit, depending on the Investor’s own situation.
In all cases involving a 1031 Exchange, the Investor must utilize a “Qualified Intermediary”, a 3rd party which holds the funds from the sale of one side of the process until the entire process is wrapped up. They may also hold title to the property(ies) of one side of the process until everything is finalized. Think of it as a way to keep the funds from being considered as comingling, or coming into the procession of the Investor. The Intermediary can often also lend guidance to handling the 1031 process. And yes, there will be fees associated. No one works for free.
The Bottom-line of 1031 Exchanges
While they can be a means to defer capital gains taxes far into the future, thereby allowing the equity funds of the Investor to grow virtually untaxed, much like a tax deferred annuity, they are not without “Gotchas”/Caveats. Should you elect to utilize this strategy, go into it with your eyes open, and with professional council.