Section 1031 of the Internal Revenue Code underlines the rules of exchanging property held for investment or productive use. If you meet the requirements, you can acquire real estate through a like-kind exchange or 1031 exchange.
The strategy involves selling a property to acquire a similar one. In a 1031 exchange, the taxes can be deferred on the sale, allowing the seller to utilize all of the equity instead of losing a significant portion to taxes.
The 4 Types of 1031 Exchanges
There are several 1031 exchange approaches available depending on your goal and situation. Let’s have a look at the types available to the United States taxpayers.
1. Simultaneous 1031 Exchange
A simultaneous exchange happens when you relinquish property and acquire the replacement property at the same time. The exchange has to happen simultaneously, and a small delay can lead to the disqualification of the 1031 benefits.
A two-party simultaneous exchange involves a one-for-one asset swap between yourself and a second party. With a three-party simultaneous exchange, you are interested in an exchange, but the second party doesn’t have a property to transfer to you. You and the second party can identify a property from a third party to make the exchange. The second party will acquire this third-party property and use it to complete the exchange with your property.
There are a couple of primary ways to conduct a simultaneous 1031 exchange. The exchanging parties can either:
- Choose to swap deeds or invite an accommodating party to facilitate the exchange.
- Hire a professional intermediary to structure everything on their behalf.
The simultaneous exchange process prevents a taxable event from occurring, meaning both parties can avoid or defer taxes. However, some complications may arise during a simultaneous 1031 exchange.
Simultaneous exchanges sometimes raise logistical issues, making it hard to accomplish them.
A common problem is when the properties being swapped are in different regions. Interstate exchanges are legal, but the distance can make finding a property in another state, communicating with the seller, and executing the transaction difficult. Since Section 1031 is in the United States’ tax code, the two properties must both be in the United States. Though other nations may have similar programs, exchanging your domestic property for an international property is not considered a 1031 exchange.
Also, finding a second- or third-party intermediary willing to undergo a one-for-one exchange within a brief time window may be difficult.
2. Delayed 1031 Exchange
This 1031 real estate exchange program is the most common. The investor relinquishes their property before acquiring the replacement property. In other words, you first transfer the property you want to give up before securing the desired replacement. Upon the transfer, a third-party intermediary controls the money gained from selling the investor’s property. If the investor were to accept the money, a taxable event would occur that would negate the 1031 exchange.
To initiate a delayed exchange, you have to market your property, find a buyer and execute the sale and purchase agreement. Next, you need to hire an independent exchange intermediary to oversee the sale of the relinquished property. You as the investor must find a qualifying replacement property within 45 days of the initial sale. The third party will hold the proceeds for a maximum of 180 days as you acquire a like-kind property.
The reason for the popularity of delayed exchange is that it gives the investor ample time to complete the transaction. However, the 45-day window for finding a replacement property can complicate the exchange process.
3. Reverse 1031 Exchange
A reverse 1031 exchange is the opposite of a delayed exchange. Rather than you selling a property first and then looking for a replacement and closing the deal, a reverse exchange begins with buying a replacement property and ends with selling the relinquished property.
In a reverse 1031 exchange, the investor acquires the real estate via an exchange accommodation titleholder. The investor must purchase the property through the exchange intermediary rather than buy it directly. It’s critical to the deal that the investor does not own both properties at the same time.
The taxpayer has to declare the real estate to offer as relinquished property within 45 days. After this period, the exchanger has 135 days to complete the sale and close the exchange.
Reverse exchanges can raise the following challenges:
- Most banks won’t fund reverse exchanges
- You cannot own the old and new properties at the same time
- Issues with tax for deed transfer may arise in some states
- Comparing equity from the old property with the new one can be a challenge
A reverse exchange could be an option to acquire an ideal property quickly for when there is a concern that the property will be off the market. A reverse exchange is also an option for when there is a need to close on the replacement property before you can sell your real estate.
4. Improvement Exchange
Also termed as a construction exchange, improvement exchanges allows investors to upgrade the replacement property with the exchange equity. That is, the taxpayer can spend the deferred tax amount on improving the replacement property before closing the 1031 exchange.
This type of exchange is suitable for people who want to acquire a replacement property that doesn’t match their needs. This real estate exchange allows you to make the necessary improvements on the real estate and include the construction as part of the exchange.
Like other exchanges, the investor must identify the replacement property, relinquish their own property, and allow a qualified intermediary to hold the funds. From there, engaging in an improvement exchange involves a few steps and limitations:
- The qualified intermediary must pay for the property renovations.
- Any renovations must occur within 180 days of the sale.
- The entirety of the exchange equity must go toward the renovations.
- The purchase contract must outline specifications for the renovations to follow.
- The renovators must precisely follow all specifications detailed in the sales contract.
- The renovations must ensure the property is substantially the same property as that which the investor relinquishes.
- The exchanger must confirm the renovations’ completion.
- The investor claims possession after renovations.
Recapping the 4 Types of 1031 Exchanges
In summary, a 1031 exchange defers tax liability for an investor selling one or more properties to buy similar real estate. The four types of 1031 exchange options used in the U.S. are:
- Simultaneous: Both parties relinquish their properties at the same time.
- Delay: The investor relinquishes their property and finds a replacement within 45 days.
- Reverse: The investor purchases a replacement property through a third-party intermediary before relinquishing their own.
- Improvement: Equity from the transaction goes to a third-party intermediary who uses it to renovate the building.
Learn More About Exchanging Real Estate With 1031 Crowdfunding
Section 1031 is a provision for business and investment property only. Therefore, you cannot swap your home for an alternative primary residence. Real estate exchanges enable taxpayers to change their form of investment without cashing out or declaring a capital gain. You can swap properties without tax obligations until the time you decide to sell for cash.
It’s essential to choose the real estate exchange model that suits you best. A minor mistake can annul 1031 privileges and lead to an unexpected sales tax. If you are interested in learning more, create a free investor account at 1031 Crowdfunding today.