Unlocking the Secrets: The Hype Surrounding 1031 Exchanges and How They Safeguard Taxable Income

What is all the hype about 1031 Exchanges and how they shelter taxable income?

If you have an investment property and are feeling it is time to liquidate it then the 1031 exchange might be the right vehicle for you to do that.

What is the 1031 exchange?

Selling one investment property and rolling the money into a second investment property, thereby entitling yourself to a TAX deferral on the capital gains as a result. This is a great way for investors to build wealth. Why, because the IRS allows you to shelter the taxable income from the sale of one property by rolling the taxable basis to another property.

When does it catch up to me? When you stop rolling over the 1031 exchange funds to other like kind properties. You can opt to wait until your retirement years when you are in a lower tax bracket. You can leave the property acquired with 1031 dollars to your heirs which offers the best scenario because in effect, you have never paid taxes on the rollover of your taxable income. Your heirs will have a stepped-up cost basis and you will not be liable for taxes on the increased value of the last property you acquired (rolled the dollars into). Lastly, you can convert the property to a primary residence after renting it for a minimum 2 of 5 years.

What are the rules of a 1031 exchange? It is imperative that you know in advance of the closing date on your investment property that you notify the title company and appoint an intermediary to hold the funds from the sale of your property wherein you wish to roll over the dollars from. Why? You must not take possession of the proceeds from the sale of a 1031 exchange property. Upon closing on the sale the dollars are wired from the title company directly to your 3rd party intermediary who will act as your fiduciary and hold the funds on your behalf for your subsequent acquisition.

Once your property is closed you have 2 timelines that are imperative to keep on your radar:

Critical Deadlines to meet:

1 - 45 Day Rule – Within 45 days of the close of your former property you must identify up to 3 potential replacement properties in writing, to the intermediary.

If the buyer fails to identify the potential replacement properties by the 45th day the exchange will be disallowed.

2 - 180 Day Rule – You must close on the new property within 180 days post the close date of the property sold. This is particularly important if you are buying a new build.

I acquired a new build as my replacement property and while it was completed before the 180 day stipulation, I had a loan lock rate that expired due to the builder not finishing the build by the original close date. That meant negotiating that the builder would pay to extend the interest rate loan lock fee. He did but it was a situation I would’ve preferred to avoid. Additionally, the market escalated in home pricing during the contract period and, the listing agent was eager to cancel the contract and, close at a higher price (with another buyer) which is not an ideal situation given I was under a time constraint. Of course, I closed on the home but not ideal so if you can avoid new builds as 1031 acquisitions I would suggest you do so.

Points to Remember – 1031 Exchanges are for investment properties and you cannot live in them for 2 years post acquisition as this is converting it to a primary residence which foregoes potentially the full tax deferral which was your objective.

You can take Boot or cash out of the closing proceeds, but this will be taxable income to you. You want to ensure you are buying a more expensive property than the one you sold, or the differential will be taxable income to you. Another point to remember is that mortgages are relevant in the whole equation as well.

If you don’t take cash proceeds at the closing table but your mortgage decreased then that also will be treated as income to you, just like taking cash proceeds. If you sell an investment property worth $2MM and the remaining mortgage balance is $1MM then you’ll need a replacement property with a loan of at least $1MM.

Your property must be “investment property”. Personal use of the dwelling cannot be greater than 10% of the number of days during the 12-month period that the dwelling unit is rented. You cannot immediately convert the property to your personal residence for 2 years post-closing on your 1031 property.

If you or someone you know needs help selling, buying or investing in a 1031 property I have personally done so and, can help you navigate doing the same.