Selling your current investment property for a replacement property through a tax-deferred exchange can provide key benefits. However, any proceeds you make on the sale of your investment property will be taxed. With a 1031 exchange, you can defer this taxation and grow your wealth as a real estate investor by exchanging your current investment property for one or more similar properties.
A 1031 exchange has many moving parts, and investors must follow all requirements to reap the tax benefits. This guide examines how investors can use a 1031 exchange for multiple properties and the rules involved in this strategy.
What Is a 1031 Exchange?
Named after Section 1031 of the IRC, a 1031 exchange is a real estate investment strategy investors can use to upgrade their current investment property for one of equal or higher value without paying taxes on the proceeds. Also known as a like-kind exchange, this method enables investors to defer capital gains taxes on the income they make from the sale of their investment property.
With a 1031 exchange, investors must reinvest all proceeds from the sale into a replacement property within a certain time limit. Any money taken out from the sale of the original property is subject to capital gains tax.
Investors can only perform a “swap” of real property, such as buildings and land. They cannot use primary residences as part of a 1031 exchange. Properties are only eligible if purchased and used for business or investment purposes, such as renting to tenants.
If you meet the exchange requirements, your investment can grow tax-deferred. This deferral can aid your financial and retirement goals as you can improve your investment portfolio and more effectively manage your wealth.
What Are the Requirements for a 1031 Exchange?
You must meet several requirements to qualify for a 1031 and gain the tax deferral advantages.
Firstly, you must identify a like-kind property for a 1031 exchange. This means the property must be similar in nature, although they do not have to be the same type of property. For example, you could swap an apartment building for an industrial building or raw land for a strip mall. Properties are generally eligible as long as they are equal or greater in value to the original investment property and are used for business or investment purposes.
Secondly, when you sell your real estate investment property, you must roll over the proceeds to a qualified intermediary (QI) as a third party to manage the transaction. A QI is an individual who facilitates the exchange and helps investors comply with 1031 exchange requirements.
Using a QI ensures you do not receive cash from the sale. Your QI will hold your funds for you until you complete the exchange. The QI reinvests the proceeds on your behalf so you never take control of the proceeds. Doing so would disqualify your exchange and make the gain taxable.
Thirdly, you must identify your replacement property or properties in writing within 45 days of selling your previous property. You must close on the new investment property or properties within 180 days after the sale. In a high-demand market, this relatively short timeline can create pressure on investors, which is why it’s crucial to use a platform that narrows down properties that qualify for a 1031 exchange.
You can split a 1031 exchange and identify more properties than you’re selling, but you must adhere to specific requirements, which we discuss below.
Remember that there is no limit on how many times you can perform a 1031 exchange. Essentially, you can roll over the gain from one investment property to another and another until you sell it for cash. If you stick to the rules and requirements, you’ll only have to pay capital gains tax once when you cash out on your property.
Additionally, your heirs will receive a step up in basis upon your death while holding a 1031 exchange investment property. The base value becomes the property’s current market worth, canceling any capital gains, meaning your heirs benefit from the increased property value without owing taxes. For example, if your children inherit your investment property that was acquired in a 1031 exchange, they can sell it for the appraised value after you pass without paying capital gains tax.
How Many Properties Can You Buy in a 1031 Exchange?
Investors generally identify three replacement properties in a 1031 exchange, which is the maximum number for investors. This is known as the three property rule. The rule states that investors can identify up to three properties regardless of their fair market value. You aren’t required to purchase all three properties, but you can. Some investors may choose to acquire only one or two of the three identified properties.
However, you can acquire more than three properties using certain identification rules. The following exceptions apply.
The 200% Rule
The 200% rule allows investors to identify four or more properties as long as the total fair market value of the properties isn’t over 200% of the relinquished property’s fair market value. For example, selling a replacement property for $2 million means an investor could identify multiple 1031 exchange properties as long as their combined value is less than $4 million.
Essentially, an investor can identify as many properties as they want in this case. When using this rule, investors can identify properties worth less than what would be permitted if they were identified alone.
The 95% Rule
The 95% rule is another exception that enhances the multi-property exchange benefits by enabling investors to identify more than three replacement properties without a limit on the total value. However, they must acquire and close on 95% of the value of the properties identified. This means that if an investor identifies more than 200% of the value of the relinquished property, they may still qualify for a tax-deferred 1031 exchange as long as they purchase a minimum of 95% of the value identified.
For instance, if the same real estate investor from the previous example identifies four properties that add up to $5 million, they must purchase at least $4.75 million. This is often a complex process for investors, particularly when more properties are involved, but it’s an effective strategy.
The 95% rule also enables investors to diversify their real estate portfolio and access more properties they actually want to purchase. However, multiple exchanges occurring simultaneously can be complicated and incur additional costs.
Both the 200% rule and the 95% rule are still subject to the same 1031 exchange timelines. If an investor identifies multiple properties in a 1031 exchange, they must identify all properties within 45 days of the sale of the relinquished property and close on all replacement properties within 180 days of the sale.
Explore 1031 Exchange Replacement Properties With 1031 Crowdfunding
As a real estate investor, you’re always looking for ways to grow your wealth and reap the maximum benefits of your investments. With a 1031 exchange, you can diversify your portfolio to hedge against risk and generate passive income. At 1031 Crowdfunding, we help our clients complete the 1031 exchange process by offering an extensive marketplace of 1031 eligible investment properties.
Our knowledgeable and experienced team will guide you through the transaction with all the details and documents you need to perform your due diligence and ensure the exchange is done correctly. Register for an investor account today to view our vetted 1031 exchange real estate properties.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.