Aug 31st, 2007 by Afiya
As a real estate investor you most definetely have (or shoud have!) heard of the 1031
exchange.
If you haven’t heard of a 1031 exchange, I would suggest studying up on this capital gains deferral strategy even if you don’t plan to use it in the near future.
I may be biased, because I love leverage, but I believe the 1031 exchange is one of the best ways to build your wealth in real estate over a period of years.
Some people like the 1031, while others like other strategies much better.
Let’s go over the 1031 exchange so you can decide for yourself whether or not to work this strategy into your overall real estate investing plan.
SIDE NOTE: If you don’t already have your short and long-term goals written down for your real estate investing business, you truly need to stop reading this now and whip out a piece of paper… and begin putting your goals onto paper.
Okay, now on to the nitty gritty of the 1031 exchange:
What is a 1031 exchange?
A strategy that enables sellers of appreciated assets such as real estate to defer capital gains taxes and “trade up or even” to another “like-kind” asset. Got it?
Because of the restrictions that the IRS has placed on this strategy, it isn’t as straight forward as some people think.
There are time restrictions… restrictions on the properties that you can identify… how many properties you can identify… how the funds must be directed while looking for a property… etc.
So, to help clear things up a bit I’ll go over these briefly.
What is a like-kind property?
Similar classes of property are considered “like-kind”. Similar classes can be:
- Investment real estate FOR investment real estate
- Male cows FOR male cows
- etc.
Of course, we’re talking about real estate, so we’ll stick with that.
Basically, all investment real estate is usually considered like-kind. So you can trade a duplex for a 12 plex… and a single family home for a duplex… or a commercial building for raw land… you get the idea. As long as it’s investment real estate you shouldn’t run into a problem with the “like-kind” rule.
What does it mean to “trade up or even” with a 1031 exchange?
In order to use the 1031, the replacement property(ies) must be of equal or greater value and with equal or greater debt (unless the seller adds cash to the deal to replace debt).
So, if you own a $200,000 duplex with $50,000 debt service, the replacement property must be valued at greater than $200,000 and you must maintain at least $50,000 debt service on the property. Truly, if you are using the 1031 exchange to build assets you should not have a problem with this rule.
What are the time restrictions with a 1031 exchange?
The time requirements of a 1031 exchange are rather simple.
It’s broken down into two distinct segments:
- Identification Period - 45 Days
This period is simply the time period that you have to identify a replacement property after your “relinquished” property was sold. The “relinquished” property is simply the property that you are selling.
In this Identification Period you have 45 days. This 45 days starts on the date of the transfer of your relinquished property (the date the property you are selling changes ownership), and goes for 45 days.
During this 45 days you must identify your desired property or properties (more about the # of properties later).
2. Exchange Period - 180 Days or the date your tax return is due for the year of the sale.
The exchange period is the time period that you must complete the exchange within. This period begins on the date of the transfer of the relinquished property (the same as the Identification Period), and ends 180 days later… OR…
… on the date of the tax return that is due for the year in which you sold the “relinquished” property. So, you can see that this takes a bit of planning. If you plan it wrong, you actually may have less than the entire 180 days to complete the exchange.
For instance, lets say that you sold your property on 12/15/06. Now, normally you would have 180 days to complete the exchange. However, your tax return is due on 4/15/07, which is only 120 days away. Since your 2006 sale will be on the tax return that is due on 4/15/07, you must complete the exchange prior to 4/15/07. Got it? If not shoot me an email.
So, when doing a 1031, it is usually best to plan the sale at a time where you get the entire 180 days to complete the exchange process.
So… in summary, you have 45 days (from the sale of your property) to find suitable properties and 180 days (from the sale of your property) to close on one or more of the properties.
Here’s a nifty little graphic showing the exchange period.
(from www.manleyandcompany.com)
Simple, huh?
Now the more confusing part…
Property Identification Rules with a 1031 Exchange -
As if thinking about the time restrictions wasn’t enough, you need to think about the values of the properties you are buying and some other things.
There are three rules that you need to be aware of when doing a 1031 exchange.
First, you need to follow one of the three rules below regarding the properties that you identify. (you use ONLY ONE of the three rule for identifying properties. One of them …. NOT two or three. )
OPTION #1: 3 Property Rule -
The maximum number of replacement properties you may identify is three properties without regard to fair market values of the properties.
What’s this mean? Simply what it says. You can’t identify more than 3 properties when using this rule. The reason to use this rule may be that you have three properties that will suffice for the entire exchange and you hope to close on one (or possibly two) of the properties. You may have one property you really like and have the other two for a safety net.
If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified.
OPTION #2: 200% Rule -
You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties. You figure fair market value of Replacement Property as of the end of the identification period.
You figure fair market value of Relinquished Properties as of the date you transfer them.
So, in plain English… if the FMV (fair market value) of the relinquished property is $100,000… the maximum total value of properties that you can identify with this rule is $200,000. This rule may be useful if you want to purchase several properties to diversify your holdings. OPTION #3: 95% Rule - This rule simply states that you can identify as many properties as you want, as long as you end up acquiring 95% of the total value of the properties identified. So, you identify 10 properties with a total value of $1,000,000… you must acquire $950,000 worth of the properties or your exchange is void. I know, these rules are kind of strict. They are strict for a reason though. Imagine having no rules… you could go out and identify 100 properties just so you have a bunch of backups. The rules make you think hard about the exact kind of property you want and penalize you huge for not sticking to the rules. Now, there is even another rule that you need to be aware of when doing a 1031 exchange (I know, kind of a pain in the a$$ huh?)You MUST trade UP or EVEN in value. What’s this mean?
Simply, you must find a property (or properties) that are at least even or greater in total FMV AND equal or greater in debt. Yes, you must trade up or equal to the amount of debt you carried on your relinquished property.
This rule makes sure that the 1031 exchange is used for its intended purpose. Its intended purpose is to allow investors to keep upgrading to more valuable property and defer the tax. If you didn’t have to trade up or even the debt, you could technically go out and find a low dollar property, put all of your sales proceeds into it, and have that property paid off.
There is an exception. If you bring in your own money to make up for some of the debt portion, then that is okay.
So, trade up or even in VALUE AND DEBT.
Here’s some examples to help clear this up for you:
Sell property worth $500,000 w/ debt of $200,000 and equity of $300,000 You must find a property or properties where when you purchase them you have at least $200,000 in debt on the new property and the property is worth at least $500,000 or more. You couldn’t trade into a property that is worth $400,000 where you would have only $100,000 in debt. 2. Sell the same property as above and want to trade into multiple properties. You find 3 properties that you want to trade into where their total value is $750,000. You’ve got the trade up part taken care of… now you just must have more than $200,000 in debt on the properties collectively to make it work. When you really crunch the number’s, it is pretty easy to stay within the rules. Okay, now that you’re completely asleep and snoring on your keyboard (I HOPE NOT!), I’ll sum this little tutorial on the 1031 exchange up.
The 1031 exchange is an extremely powerful strategy for building your wealth in real estate. It helps you leverage your capital and defer the capital gains tax… which is pretty darn powerful when you really look at the numbers (we’ll go over the leverage aspect on another post).
Although doing a 1031 exchange is an excellent way to increase your wealth in real estate, it isn’t usually something that you will want to do on your own. You saw all of the restrictions and rules I told you about earlier… and those aren’t even all of them!
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If you are the kind of person who likes to do things on their own to save some money… or you are a real estate professional who wants to begin adding a new stream of income to their business… we found an excellent resource for teaching you step-by-step how to do the 1031 yourself, complete with:
- All of the forms
- A proprietary software program that basically does all of the thinking and paperwork for you
- Multimedia disks that walk you through the steps one by one created by one of the top 5 1031 exchange accommodators in the nation
- and a bunch more.
I’ve personally seen this resource and have seen the types of results that it produces. It is a complete take home course, so you can put it right on your shelf for easy reference.
Anyhow, the link below explains it much better than I ever could.
Just for full disclosure, yes, that is an affiliate link. However, I only refer products that I know work and are the top of the industry. No fluff… no guru crap… just stuff that works. If you like it, excellent!
