The term “1031 Exchange” originates from section 1031 of the Internal Revenue Code. This permits an investor to substitute their investment property, which would then be known as the relinquished property, with another one that is similar or labeled as “like-kind”, which would later be known as the replacement property. The investor is given an option to defer the taxable gain temporarily.
Investors are open to using the 1031 exchange since they can end up paying between 15% to 30% in taxes from the sale of a property. By using this strategy, Texas investors can plan their real estate portfolio more and build their wealth.
To qualify for a 1031 exchange in Texas, there are certain rules to follow. The first rule is that the relinquished property must be utilized for business or considered as an investment. So, it must be considered a business property. By this definition, personal homes are automatically excluded from the list. Vacation houses that aren’t used as rentals are also exempted from the category, as well as fixer-upper properties with an objective to be resold by the investor. Although vacation homes can qualify under certain conditions, you must seek legal expertise on this.
For a 1031 exchange to be successful, you must observe the following:
- Both properties must be used for investment
- Both properties must be considered “like-kind”
Examples of qualified 1031 exchanges:
“Like-kind” properties can be broad in their meaning. You can swap real estate such as:
- A ranch for an apartment complex
- An office building for an apartment
- An apartment for a shopping center
- A shopping center for a farm
- An industrial building for raw land
Types of Real Estate Exchanges
There are 4 types of 1031 exchanges you can do:
1. Delayed exchange
In this exchange, an investor is required to sell the relinquished property prior to purchasing the replacement property. This is more convenient to the investor since they don’t have to have a big financial reserve to buy a property and instead use the sales proceeds for the transaction.
The challenge in a delayed exchange is to find a buyer immediately and the exchange has to fit the 180-day period. There’s also a restriction of only 45 days to find potential replacement properties.
2. Simultaneous exchange
In this exchange, it’s required that the buying of the replacement property and selling of the relinquished property occur on the same day. Otherwise, the transaction can be deemed as disqualified. Once this occurs, the investor cannot do a tax deferral resulting from the sale of the relinquished property.
There are 3 ways to fulfill the simultaneous exchange:
- Three-party exchange with an “accommodating party”
- Three-party exchange with a Qualified Intermediary
- Swapping deeds with another real estate property owner
3. Construction or improvement exchange
In this exchange, the investor is allowed time to make improvements on an investment before the transaction takes place. The investor is granted 180 days to finish all the renovations.
There are 3 requirements to meet to defer the capital gains taxes:
- The full equity of the exchange must be spent on all the construction costs to improve the property. It must be done within 180 days.
- The value of the property must match in value or be greater than the previous original property once improvements are performed.
- All the construction must be finished within the allotted 180-day period.
4. Reverse exchange
This exchange entails looking for a property to invest in before pushing through the sale of your current property. This means having enough capital to purchase the new replacement property. Although this requires extra funds from the investors, the benefit is they can gain more time in selling the property in their hands. If the economy is performing well, then it also means that the investors can earn extra money derived from market appreciation of their present property.
It’s important to remember though that investors are restricted to having only 45 days to determine the property they want to sell. Another restriction is that the entire sales transaction must wrap up within a 135-days period.
Important terms to remember in a 1031 Exchange
To consider properties as like-kind, they don’t have to look similar. The exchange can involve exchanging raw lands with commercial centers and apartment complexes with office buildings. If both properties are in the US, then there can be a 1031 exchange as long as they meet particular conditions.
Investment property comes down to business real estate in a 1031 exchange. This can refer to condo units, townhomes or shopping centers. As long as they’re not for personal use, they can be qualified for an exchange transaction.
Like-kind exchanges exempt personal properties such as cars, homes and private yachts. This also includes cash, stocks, bonds, notes and other securities counted as account receivables.
Boot is essentially a non-replacement property because it does not fulfil the like kind requirments. It can represent cash, debt reduction or any form of personal property provided in a 1031 exchange. Receiving boot disqualifies you from a full tax-free 1031 exchange.
Same title holder
Basically, this means that the listed name on the property title of the relinquished property and the replacement property must be one and the same.
An exchange period refers to the time given to finish the acquisition of a new like-kind replacement property to exchange with the current relinquished property. The fixed exchange period is 180 calendar days. It’s non-extendable in observance of weekends or holidays.
A set period to identify which property an investor chooses to replace for the like-kind exchange of personal property. The fixed identification period is 45 calendar days. It’s non-extendable in observance of weekends or holidays.
You can check out the IRS’s 1031 exchange fact sheet for more information. As an investor, you want to experience the full benefits that 1031 exchanges can offer when it comes to federal income tax return.
As much as 1031 exchanges can be advantageous as a strategy for investors in wealth-building, they require a lot of technical knowledge to execute legally. From knowing how to pay tax to navigating tax deferred exchange, having an expert by your side can help. It’s advisable to consult with an expert tax professional or tax advisor to perform a 1031 exchange in Texas. A tax advisor is essential to navigating the law and a tax deferral.
If you need assistance to successfully navigate a 1031 exchange in Texas, please contact Bigham & Associates at (512) 339-8812.