What is a 1031 property exchange?
As the name suggests, this unique investment strategy allows two parties to trade certain types of properties, effectively streamlining the sale and purchase process. This also enables them to avoid the high penalties of capital gains taxes, which can typically range from 15-20%, greatly diminishing the profits a typical sale would bring.
The name is derived from Section 1031 of the IRS Code
, which delineates all of the qualifying properties and regulations for making an exchange. Others may refer to this investment trading as a Starker exchange
after a 1970’s legal case involving the Starker family and their 1031 property exchange.
How does it work?
Let’s say that you are in possession of a Mission Hills luxury home. You have used this house as a rental property for years. Your go-to Mission Hills real estate agent has kept you abreast of some upcoming changes to the neighborhood, and it seems the perfect time to shift your investment strategy. You believe that a commercial property would be more lucrative. You have an associate who has admired your property for years and has more than once remarked he’d love to get the first opportunity to invest in it if you ever decided to sell. His primary investment experience is in commercial properties, and you’re pretty sure you could negotiate a satisfactory exchange for both parties. You meet, discuss the two properties, and agree to trade. You are now the owner of a shopping center, and he just acquired a Mission Hills luxury home. This is the simplest type of 1031 property exchange
Finding two investors who are looking for the exact type of property the other possesses can be tricky. There are provisions in place that allow for a three-party process or delayed exchange. For this transaction, there must be a go-between mediating between parties. The go-between will hold the funds earned from the first sale and use that same money to purchase the new one.
Timing is everything in a delayed exchange. The cash cannot be used by the seller, or the transaction will no longer qualify as a 1031. From the date of sale, the investor must select a replacement property and provide written notification to the go-between within 45 days. It is admissible to choose up to three properties as potential replacements as long as the purchase is finalized with at least one of them. The second time constraint involves cloning the new property. The transaction must be completed within 180 days of the original property’s sale date.
Sometimes cash remains in the hands of the intermediary following the acquisition of the new property. This sum is nicknamed “boot” and will be subject to taxation as capital gains when the funds are returned to you.
What are the restrictions?
The rules for exchange are very specific and detailed for each category of investment property. Vacation homes must be a viable source of income, and residential properties are only considered within limited parameters. For instance, if you’re looking to use a property for your primary residence, it must be utilized as an investment for the first year, with appropriate rental terms for at least 14 days or more. Talk with a Mission Hills real estate agent
to learn the specific limitations and qualifications for your investment property. All exchanges must take place on properties within the United States.
Property swaps do not have to be limited to a single transaction. Qualifying exchanges can take place over and over an unlimited number of times over an unlimited number of years. It is only when you cash out of the process that you will pay a capital gains tax
, and only on that final transaction.
Excellent strategy for estate planning
If you are looking for a means to provide well for your heirs, consider leaving the property you’ve acquired through 1031 exchange to them. If you die with this property still in your possession, the taxes you managed to defer are canceled. They will not be required to pay capital gains taxes for transactions already completed, and well-chosen properties will offer the heirs an appreciated value.
It can get complicated
The Tax Cuts and Jobs Act
changed the rules of the 1031 exchange in 2018, reducing the types of properties that can qualify for 1031 and increasing the number of regulations governing the transaction. Only real estate qualifies now, and no longer can franchise licenses or personal properties, such as airplanes, be exchanged. The timelines for the 45-day and the 180-day transaction window run concurrently and must be adhered to strictly. Providing a detailed and accurate IRS Form 8824 with tax submissions is vital to escape stiff penalties, and the paperwork is closely monitored.
With rules such as these, as well as technical terminology and specific delineations for various types of property (vacation homes versus business properties), trying to make a 1031 property exchange on your own is generally a bad idea. There are too many ways things can go awry and too many technicalities. This is ultimately why you need a credible realtor to walk through the process with you. Nick Emerson
is an experienced Mission Hills real estate agent with extensive experience and knowledge of 1031 property exchanges. Reach out to Nick
with all of your questions and start growing your portfolio today.