1031 Exchanges in Real Estate Investing

1031 Exchanges in Real Estate Investing

Nikki Williams, Esq.
Watson Sloane PLLC

The real estate market is an integral part of the economy and is generally one of the measures used to gauge the health of the larger economy. Federal, state, and local governments and agencies often establish policies to encourage real estate investors to actively purchase and sell properties. Section 1031 of the Internal Revenue Service Code is a regulatory tool that encourages the investment and reinvestment in real estate.

Internal Revenue Service Code 1031 permits what is commonly referred to as 1031 Exchanges. 1031 Exchanges serve as a beneficial tool for real estate investors to defer the payment of capital gains taxes and make use of the profit gained from the sale of a property to invest in another property. When used properly, rather than experiencing a reduction in profits as a result of capital gains taxes, the investor has more funds to use for additional ventures.

Who Can Take Advantage of a 1031?

Real estate investors who sell an investment property for a profit and would like to defer payment of the capital gains taxes on the sale of the property can take advantage of a 1031 Exchange.

Generally, capital gains tax must be paid on the profit realized from the sale of a real estate investment property. If an investor owns the property for less than a year before it is sold, the investor is required to pay short term capital gains tax. Properties that are owned for more than a year are subject to long term capital gains tax. Short term capital gains tax rates range between ten percent (10%) and thirty-seven percent (37%) and are generally based on the ordinary income tax rate. The long-term capital gains are taxed at either zero percent (0%), fifteen percent (15%), or twenty percent (20%). A real estate investor may utilize a 1031 Exchange in order to defer the payment of these capital gains taxes.

How Does a 1031 Exchange Work?

1031 Exchanges are also referred to as “like-kind exchanges” because the money received from the sale of the property must be used to purchase other real estate. Except for in limited circumstances, once the property is sold, the profits must be delivered to and held by a qualified intermediary. The qualified intermediary will hold the money until it is used to purchase the replacement property.

The investor is required to identify the replacement property within forty-five (45) days of the sale of the current asset. Although the replacement property must be a like-kind property, the real estate property is not required to be the exact type of real estate property as the property sold. For example, if an investor sells a retail shopping center the replacement property can be a multifamily residential property.

The investor must close on the replacement property within one hundred eighty (180) days from the sale of the prior real estate asset to comply with the requirements of the 1031 Exchange. If the profits are not re-invested in the replacement property within the requisite timeframes, the investor risks losing the protections afforded under the 1031 Exchange and may be required to pay the capital gains tax.

When Should a 1031 Exchange be Considered?

A real estate investor should consider a 1031 Exchange when the investor (i) prefers to defer the payment of capital gains taxes for tax and profit reasons; (ii) is considering reinvesting the profits in other real estate; or (iii) has an investment strategy that includes leveraging profits from the sale of prior investments to reinvest in real estate.

Can the Replacement Property be Purchased Prior to Sale of the Current Real Estate Asset?

Section 1031 of the Internal Revenue Code allows what is referred to as a “Reverse 1031 Exchange”. The Reverse 1031 Exchange allows an investor to identify and purchase the replacement property prior to the sale of the current real estate. However, the replacement property must be titled in the name of an Exchange Accommodation Titleholder. The Reverse 1031 Exchange also has other requirements that must be met in order to properly take advantage of this tool.

The attorneys at Watson Sloane are experienced in 1031 Exchanges and the requirements and can assist with all aspects of 1031 Exchanges and Reverse 1031 Exchanges.