In a previous blog we explained the basics of buying and selling investment properties via a 1031 Tax Deferred Exchange. In this one we discuss how, by using a 1031 Exchange, investors can expand their options.
Many people who are new to real estate investment define the meaning of “like-kind” too narrowly. They also assume there is only one “route” – sell and buy (relinquish and acquire) in a simultaneous transaction. Let us begin with what the IRS means by “like-kind” and then look at the three routes investors have available.
The IRS defines the term rather vaguely. Like-kind property is real estate held for trade, business or investment. Investors who have a desire to improve the world may, for example, want to buy low quality residential property, renovate it and sell it, then use the profit to repeat the process. Others want to buy, renovate, and rent the property out to tenants. At some point, they will sell that property and use the proceeds to buy more expensive property and, again, repeat the process.
Some investors inherit property. It may be a relative’s home or some farmland, just to take two examples. Some investors may have owned a commercial business such as storage units, parking lots, a small manufacturing plant, or a retail store for example. The IRS allows any of them to be “exchanged” for “fix-and-flip” or “fix-and-rent out” residential property. The residences can be single- or multi-family.
This means an investor’s options for what can be “exchanged” expands quite considerably, thus deferring all capital gains tax (CGT) due, to roll into the new investment.
The Three 1031 Exchange Routes
- One or more properties may be relinquished and other property(ies) acquired in a simultaneous transaction. But that is not the only route.
- A deferred exchange transaction is one where properties are sold to new owners, but the proceeds are held by the qualified intermediary (QI) for the next step. The investor then has 45 days to name potential new investments. This window enables a thorough search for ideal replacement properties. The investor then has another 135 days to sign contracts and close on the replacements, making 180 days in all. Such flexibility expands the options.
- A reverse exchange transaction is one where an investor “acquires” new property but does not “relinquish” currently-owned property for a maximum of 180 days. A QI will explain and manage the process. What matters is this process enables the right replacement property to be acquired at the right time and existing properties are sold later, when ready, willing, and able buyers are found.
When investors understand the flexibility that the IRS has built into 1031 Exchanges, they are able to defer CGT, maximize profitable sales and purchases, and complete everything in a time frame and sequence that delivers the greatest benefit.