Like-kind real estate exchanges, known as 1031 exchanges, have been an integral part of real estate investment for the last century. The first like-kind exchanges were authorized 100 years ago under the Revenue Act of 1921. While the rules have evolved several times since, the basic premise is the same — 1031 exchanges allow real estate investors to defer capital gains taxes on a sold property if they acquire a new property of equal or greater value within the prescribed time period. Under current guidelines, the old and new properties can be of nearly any type as they are “held for productive use in trade or business or for investment.” Like-kind exchanges can include rental housing, commercial buildings, land, retail properties and more.
So why are 1031 exchanges important? Aside from the fact that everyone wants to reduce their tax bill as much as possible, like-kind transactions allow investors to grow their portfolios and increase their buying power on subsequent transactions. It kicks the proverbial can — in this case, capital gains taxes — down the road until the property is sold without an exchange. Annual 1031 exchange transaction volume currently exceeds $100 billion. One study found that 88% of replacement properties acquired through 1031 exchanges were disposed of through a subsequent taxable sale, not another like-kind transaction — meaning the government does recoup the taxes for most transactions.
With 1031 exchanges, the timeline is critical. Each step must be executed by the right team adhering to specific deadlines. An average timeline would go as follows:
- First, investors would speak to their real estate professional about their desire to execute a 1031 exchange. In this discovery phase, the investor and realtor will begin casually reviewing the market for potential replacement properties of equal or greater value than the property to be sold.
- Once investors are satisfied with the overall field of potential acquisition properties, the relinquished property is put on the market. The investor’s attorney will file the appropriate 1031 paperwork as the closing date approaches.
- When the relinquished property is sold, the proceeds go to a qualified intermediary (QI), which holds the funds through the rest of the process, similar to a title company.
- Investors have 45 days after the relinquished property’s closing date to submit a list of up to three potential acquisition properties. Remember, there would have been an initial exploration of appropriate properties before the process even began, with a more extensive search as the relinquished property went into contract.
- Investors must close on one of the three nominated within 180 days of the relinquished property’s closing date. Considering the initial search legwork and standard closing timeframes, that 180 days should be plenty of time to get the deal done.
What happens if there’s a change of circumstances and the investor can’t execute a like-kind sale within 180 days? The 1031 can be canceled and the investor forfeits their initial payment, roughly $750, to the intermediary. They must wait the full 180-day period to receive their funds from the sold property. Of course, typical capital gains taxes then apply. The fact is there’s very little downside to not following through on a 1031. And while it is possible to do a reverse 1031 exchange, buying a new property before the old property sells, the financial and legal requirements are a bit tougher.
Like most real estate transactions, an experienced and knowledgeable team is critical. Investors should have not only their real estate broker, mortgage broker and attorney involved, but they should also be in touch with their tax accountant to ensure every detail is reviewed.
What does the future hold for 1031 exchanges? No one has a crystal ball, so there’s no way to know for certain. This section of the tax code has benefited investors large and small for 100 years. A proposed $500,000 limit on deferred gains appears positioned to dampen benefits for mega-developers and ultra-wealth investors, but changes could also trickle down to others.
Renters could potentially see higher monthly housing costs as investors try to offset taxes and the real estate market, especially in high-tax states, could be adversely impacted. A full 63% of all realtors reported having participated in a 1031 exchange.
For investors looking to take full advantage of the existing 1031 exchange benefits, there’s no time like the present.