How to Help Your Investors Avoid Capital Gains With a 1031 Exchange
With the massive gains in appreciation, real estate investors have billions of dollars of equity that is tied up in their properties. The challenge many real estate investors face is how to sell an investment and avoid paying the hefty taxes on the Capital Gains.
The not so simple solution for most is using a 1031 Exchange… But how can you help real estate investors if 1031 Exchanges are so complicated. Well let me try to shed some light on it for you and make 1031 Exchanges easier to understand.
What are Capital Gains?
A Capital Gain is the net increase of an investment’s value that is realized when an investment property is sold. Capital Gains on Principal Residences are excluded up to $250,000 for a single tax filer or $500,000 for a joint tax filer.
Principal Residence
A Principal Residence is defined as a property that the owner occupies for two of the past five years. This is verified by tax records, drivers license, and utility bills. The property cannot be rented for more than two weeks a year during the time it is considered owner occupied.
Investment Properties
Any real estate that is used with the intent of generating income through rental income or appreciation. This can include land, condos, and single family homes. When an investment property is sold for a profit, the owner will owe taxes on the Capital Gain.
How to Avoid Capital Gain Taxes on Investment Properties
There are no exclusions for capital gains on investment properties. So, to avoid hefty capital gains taxes many investors will choose to move into their investment property for two years, thus converting it from an investment property to a principal residence. Others will use a 1031 Exchange to defer the Capital Gains to a later date.
Improvements that Reduce Capital Gains
Capital Improvements may be added to the Cost Basis of the property, thus reducing the taxable Capital Gain. These repairs are more than just your typical maintenance.
Capital Improvements are upgrades and enhancements that add value to or improve the useability of the property. They can include new kitchens, bathrooms, room additions, roofs, driveways, or other improvements that restores or improves the property. These expenses must be depreciated over their useful life.
Other Expenses that Reduce Capital Gains
Standard costs to sell real estate can also reduce the Capital Gain on the sale of a property. This includes real estate commissions, legal fees, transfer, taxes, title insurance policy fees, and deed recording fees.
How Capital Gains are Calculated
Let’s say your client bought an investment property 10 years ago for $200,000 (Original Purchase Price) and during the time they owned it, they did $50,000 in Capital Improvements. For 1031 purposes Capital Improvements can be added to the Cost Basis lowering the overall Capital Gain.
However, during the time they owned it they also depreciated the property on their taxes by $25,000. Depreciation must be subtracted from the Cost Basis, since the IRS will recapture the depreciation when the property is sold.
Therefore, the Net Cost Basis of the property would be $225,000 (($200,000+$50,000)-$25,000 = $225,000).
Next, let’s assume the Estimated Sales Price of the investment property is $500,000 and to sell they will pay typical commissions, title insurance, and closing costs. The total of these fees come to $45,000 (Costs to Sell).
We can estimate their Capital Gains by subtracting the Costs to Sell and the Cost Basis from the Estimated Sales Price. ($500,000-$45,000)-$225,000 = $230,000). In this case the estimated Capital Gains would be $230,000.
How Much is the Capital Gains Tax Rate?
Chart Courtesy of NerdWallet.com
Your client’s capital gains tax rate will depend on their current tax bracket, the length of time that they held the property and whether or not the property was used as a primary residence for two of the past five years.
Capital Gains on real estate held less than one year are considered Short-Term and are taxed as ordinary income, which could be as high as 37%. Long-Term Capital Gain rates range between 15-20% depending upon the filing status and tax bracket.
However, for investment properties that have been depreciated over time. The tax rate for the portion that was previously depreciated is taxed at a higher rate of 25%. This is called Recapture of Depreciation.
To avoid losing up to 25% of their gains many investors will use a 1031 Exchange to buy one or more properties to replace the one they sold and defer the capital gains to another time.
What’s a 1031 Exchange?
1031 Exchange refers to section 1031 of the Internal Revenue Code, which allows an investment property to be exchanged for a “like-kind” investment property, thus deferring the taxes that would normally be paid on the Capital Gains from a sale.
1031 Exchanges originated from the early 1920’s with the Revenue Act. This law permitted property owners to trade similarly valued properties with one another and since they were traded and not sold the IRS deemed there was no taxable event for the government to tax the Capital Gains.
In 1984 the section 1031 tax code was amended to allow for the trade or “exchange” to not be a simultaneous event, thus the current 180 day 1031 Exchange Process was formed.
Rules of a 1031 Exchange
- Must be titled the same
- Must replace the value
- Must replace the debt
- Must use all the funds, not to be taxed
- Must exchange for “like-kind” property
- Must Identify in 45-days
- Must close in 180-days
- Must use a Qualified Intermediary
- Must hold the replacement property for two years
- Must NOT use the property as principal residence for two years
- Must rent the replacement property at market value
- Must not have access to proceeds until the 1031 Exchange process is complete
How does a 1031 exchange work
A 1031 Exchange is the process where a person sells one investment property (Relinquished Property) and purchases another “like-kind” property or multiple properties (Replacement Properties) of equal or greater value than the property sold.
The proceeds from the sale may not be received by the seller (Exchangor). Instead they are transferred to an Qualified Intermediary who will hold the funds until the Replacement Property is identified and purchased.
When all of the proceeds from the sale of the Relinquished Property are used for the purchase of the Replacement Property the sale is considered an Exchange and is not a taxable event.
Boot
Any proceeds from the sale of the Relinquished Property that is not used to purchase the Replacement Property is called “Boot” and is subject to tax. Additionally, if the Relinquished Property has a loan the Replacement Property must also have equal or greater debt. If the debt on the Replacement Property is less than the previous debt on the Relinquished Property the difference is called “Mortgage Boot” and is subject to capital gain tax.
This is important to note since many investors will want to only use the sale proceeds to buy a lesser priced property and not have a loan. Doing this will not satisfy the requirement of replacing the value in a 1031 Exchange.
“Like-Kind” Property for a 1031 exchange
One of the most important and confusing conditions of a 1031 Exchange is the “like-kind” property rule. This states that the Replacement Property must be “like-kind” to the Relinquished Property.
To make this as simple as possible, think of like-kind property as what the intended use is from an investment mindset versus the intended use from a practical sense. A single-family home that is rented to produce income and appreciation is not similar in a practical sense to a farm that is producing income from selling crops. However to the IRS they are “like-kind” since the intended use is an investment.
The Internal Revenue Code defines a “like-kind” property as any real estate within the US that is held for investment, trade, or business purposes. A “like-kind” property cannot be used as a principal residence or a vacation home for longer than 14-days in a given year.
Below is a short list of properties that can and cannot qualify as “like-kind” in a 1031 Exchange.
List of Like-Kind Properties
| Property Type | Like-Kind |
| Short-Term Rental (VRBO) | YES |
| Rental Property | YES |
| Speculative Land | YES |
| Second Home | NO |
| Time-Share | NO |
| Apartment Building | YES |
| Trailer Park | YES |
| Commercial Building | YES |
| Land for Growing Crops | YES |
| Delaware Statutory Trusts (DST) | YES |
| Office Condo | YES |
| Principal Residence | NO |
Before you advise your clients to do a 1031 Exchange, you must know the important dates and deadlines to help then avoid paying Capital Gains.
1031 Exchange Important Dates and Deadlines
To insure a successful 1031 Exchange and for your investor to not be charged Capital Gains tax, the sale and purchase must abide by specific dates and deadlines.
45-Day Deadline
The first deadline is the requirement to identify the replacement properties within 45-days. This allows the Exchangor to look for and identify up to three potential Replacement Properties with no limit on the total replacement value.
The 200% Rule
The seller may identify up to three properties of any value. However if they identify four or more properties the total combined values cannot exceed 200% of the value of the Relinquished Property. This rule prevents investors from naming every property in the MLS as a potential replacement property.
If the seller does not identify any replacement properties within 45 days, all the proceeds that are being held by the Qualified Intermediary may be returned on the 46th day but are now subject to Capital Gains tax.
180-Day Deadline
The second important deadline for a successful 1031 Exchange is that the purchase of the previously identified Replacement Property must be completed within 180 days from the sale of the Relinquished Property.
If properties are identified and are not purchased within the 180 days the proceeds from the sale or the Relinquished Property must be held by the Exchangor until the expiration of the 180 days. At that time the proceeds will be returned to the seller and subject to Capital Gains tax since the 1031 Exchange was not completed.
To help you gain a better understanding of how you can help a client do a 1031 Exchange I will walk you through a quick example.
Example of a 1031 Exchange
A client has a single family investment property in Denver CO. that they wish to sell and purchase two duplexes in Chattanooga TN. The home in Denver is valued at $600,000 and has a loan of $300,000. After the sale and costs to sell of $48,000 they will have new proceeds of $252,000.
Since the proceeds from the sale may not be given to the seller, you must find a Qualified Intermediary to hold the funds until the purchase of the replacement properties are completed. The QI will also complete the necessary paperwork that the title company and IRS will need to ensure the transaction was completed correctly.
Once the Relinquished Properties sale is complete, your seller must identify three “Like-Kind” replacement properties within 45-days. In this case the seller is exchanging the single family rental property in Denver for two duplexes in Chattanooga TN that will be used for the purpose of generating income through rent and appreciation, therefore this is a “Like-Kind” transaction.
Replace the Total Value
To avoid the taxes on the capital gains, 100% of the replacement value of the Relinquished Property must be replaced by equal or greater value of the replacement property or properties.
Therefore, our seller must find properties with a total value equal or greater than $600,000. For this example our seller identified and contracted on two duplexes for the combined sales price and replacement value of $640,000.
Once the properties are placed under contract, the transactions must be completed within 180 days from the date of the sale of the Relinquished Property.
The seller must also use the full proceeds from the sale of the single family home in Denver on the purchase of the duplexes. Otherwise, any unused portion or “Boot” may be subject to Capital Gains tax.
Since the proceeds of $252,000 from the sale of the home in Denver isn’t enough to cover the combined purchase price of $640,000 for the two duplexes, the investor will need to either get a loan or bring in the additional cash to make up the difference.
The Bottom Line
If you want to work with real estate investors then you must know the in’s and out’s of 1031 Exchanges. As real estate properties continue to rise they are going to become more common and investors are going to need agents that can guide them through a successful exchange.
FAQ
What does a 1031 exchange cost?’
The cost for a typical 1031 exchange can range from $500 to $1200. The main expense is paid to the Qualified Intermediary for preparing the required documentation and holding the proceeds from the sale until the exchange is completed.
Can you 1031 Exchange a Primary Residence?
A 1031 exchange is used to defer the capital gains taxes on investments only. Principal residences, second homes, and time-shares are not considered investment properties to the IRS.
What is a DST?
A Delaware Statutory Trust (DST) is a fractional ownership in larger investment properties, such as medical offices, industrial properties or multifamily apartments. A DST provides more options for investors that don’t want to manage properties or desire more diversification. Finding eligible properties is also less time-consuming because investors are exchanging into existing investments that are already under management.
What are the Disadvantages of a 1031 Exchange?
- Additional paperwork, regulations, and fees
- Meeting the 45-day rule
- Closing in 180-days
- Replacing the value of the Relinquished Property
- Replacing the Debt of the Relinquished Property
- The risk of greater tax liability if the Capital Gains tax rate increases in the future
Do you Ever Pay Taxes on a 1031 Exchange?
Yes, a 1031 Exchange is a way to defer taxes to another day in the future. Always advise your clients to speak to a CPA to discuss the benefits and risks of a 1031 Exchange.
How Long Must You Hold a Property After a 1031 Exchange?
To avoid a tax penalty for not purchasing a “like-kind” investment you must hold the property and use it for the same purpose for two-years after the purchase date.
How Soon Can You Move Into a Property After a 1031 Exchange?
The IRS is very clear that any property that is purchased as an investment may not be used as a principal residence for a minimum of two-years and for short-term or vacation rentals the Exchanger may not use the property more than 14-days each year.
Additionally, it is advised that if the intention is to move into the property to gain Primary Residence status the property should be held for a minimum of five years prior to sale.
What does a Qualified Intermediary do?
The Qualified Intermediary holds the exchange funds in a separate bank account for the benefit of the Exchanger until the funds are used to purchase the Exchanger’s Replacement Property.
The Qualified Intermediary also prepares the documentation for the 1031 exchange. This includes the Exchange Agreement, Assignments of Purchase and Sale Agreements, Notices of Assignment to both the buyer and seller, the Replacement Property Identification Notice and lastly all the accounting and tax forms.
Who can be a Qualified Intermediary?
While the IRS doesn’t require a person to have a license or certification to be a Qualified Intermediary, it does have specific exclusions for any person(s) that may have a conflict of interest with the parties in the exchange.
Any person who has acted as the Exchangor’s employee, attorney, accountant, investment banker, investment broker, real estate agent within the two year period preceding the date of the sale of the relinquished property by the Exchanger. is treated as an agent of the Exchanger and is specifically disqualified from being a Qualified Intermediary. Additionally, children, parents, and siblings are also disqualified as Qualified Intermediaries.
Why are Unused Proceeds Called “Boot”?
The 1031 Exchange originated over a hundred years ago when property owners bartered for property. Farmers would trade land for land and livestock or an ox or money. These additional items of value were known as Boot. Today, cash received or mortgage not replaced is known as equity or mortgage boot.
Can you use 1031 Proceeds to Make Repairs to Replacement Property?
The simple answer is No. Any repairs to the Replacement Property must be paid from additional funds or loans. In some circumstances 1031 Improvement Exchanges do allow for repair but they require much more planning and expertise than a typical 1031 Exchange.
Can 1031 Exchange Proceeds be Used to Pay Fees?
The IRS only allows fees that are required to purchase the Replacement Property. These fees include title fees, real estate taxes, property insurance, and escrow fees.
However, property inspections, appraisals, surveys, and loan origination fees are NOT considered required and must be paid out of pocket.
