As an active real estate investor, there will come a time where you need to sell one investment property and buy another. Perhaps the market has appreciated and it’s time to cash out and reinvest your earnings in another deal. Great! But what do you do about the hefty Capital Gains tax you’ll face with the sale of the first property? At this stage in the game, you’ll need to develop a better understanding of the glorious 1031 exchange. This (not so) simple IRS code section can make or break your real estate transaction. This article will explore the various 1031 Exchange rules that most real estate investors will eventually encounter.
What is a 1031 Exchange?
Let’s start with the basics. What exactly is a like-kind exchange? A 1031 Exchange, also called a “Starker Exchange ,” is a tax-deferral solution used by smart investors to switch out one investment property for another. By doing so, the investor defers paying the Capital Gains tax, and he can keep exchanging until he’s ready to cash out and pay it.
We’ve already talked about 1031 Exchanges here on this blog. Below, we’ll examine how to structure a like-kind exchange and examine 1031 Exchange rules in California to ensure a smooth transaction. Your first step in selecting a property to exchange is to make sure the property will benefit your investing goals. Our free downloadable deal analysis spreadsheet can help.
Once you have an idea of what you are working with, begin the process of structuring your exchange. 1031 Exchange rules are straightforward, but study them carefully.
In a 1031 exchange, you can identify up to three properties you’d like to exchange for, provided you close on at least one of them.
1031 Exchange rules at a glance
- The first rule to keep in mind is that you must be exchanging one property for another property of similar or higher value. The 1031 Exchange rules require that both the purchase price and the new loan amount be the same or higher on the replacement property.
- The properties being exchanged must also be considered “like-kind,” although there are some variables to take into consideration. “Like-kind” means that the properties must be similar in nature, or used for similar purposes, but the rules are surprisingly liberal here. It’s ok to exchange a strip mall for ranch land in a 1031, but you’ll need to be aware of HOW you do it. The primary focus of this law was initially to ensure the properties would be used for the same purpose, but today you would be surprised at what can be considered “like-kind.”
- An additional rule for your 1031 Exchange is that the property can be used for business or as an investment property only.
- The seller of the old property and the buyer of the new property must be the same taxpayer.
- Once filed, the seller has a 45 day identification window to pick his property, and then a 180 day purchase window that must be respected between the time when the first property and second property close.
4 types of 1031 Exchanges
There are four types of 1031 Exchanges, allowing investors to structure an exchange in specific ways so as to meet their particular goals. Let’s start with some definitions so you can identify the right one for your situation:
1. Simultaneous Exchange
A Simultaneous Exchange is the original intention of the 1031. Essentially, it allows investors to relinquish and close on their replacement property in the same day. This option is not very common as investors typically have to do a little legwork to prepare one or both properties for the exchange.
2. Delayed Exchange
The delayed exchange is the most common 1031 in use. By using this type of 1031 Exchange, the investor can sell their investment property and find a replacement property within a specific time frame.
3. Reverse Exchange
The purpose of a reverse 1031 Exchange is to allow the investor to buy first and pay later. In order to qualify, this type of exchange must be an all-cash purchase and most banks are reluctant to lend in these cases. Why? You cannot be on the title of the replacement and the relinquished property at the same time. However, there are workarounds to this rule, like creating an LLC that can take the title of the replacement property until you sell the original property and transfer it to your name.
4. Construction / Improvement Exchange
When the property an investor wants to buy costs less than the one relinquished, which breaks the rules of a 1031, investors can use this particular type of 1031 Exchange to use the remaining funds to improve the property they want to buy.
Additional rules for a 1031 Exchange in Santa Barbara
In order to use a 1031 Exchange in California, there are a few additional rules to keep your eye on:
- If you are based in California, you may encounter “Related Party” rules. Let’s say the old property is sold to a related party – this may include members of the same family, company or organization. If the property isn’t held for two years before selling, the tax deferred by the 1031 Exchange is due. You can limit related party issues by addressing those issues before you begin to structure the exchange.
- A qualified intermediary is used to do the exchange, and specific standards for who that person can be are in place. The qualified intermediary acts as a custodian for all the exchange funds.
- California also has something called a Clawback Provision, which involves an exchange where the replacement property is out of state. Non-residents are required to file a nonresident income tax return within the year the replacement property is sold.
A final resource for real estate investors
With the right advisors, a 1031 Exchange in Santa Barbara is a feasible, simple process so long as it is structured appropriately. The qualified intermediary of your choosing will be a valuable asset to help you structure the exchange in California. Zia Group is here to help to analyze whether a like-kind exchange will work for your situation and help you meet your investment goals.
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