The most seasoned real estate investors know all about how to take advantage of 1031 exchanges, but a lot of people aren’t as familiar with how they work. In a basic sense, a 1031 exchange will allow you to defer paying the capital gains tax on property dispositions, which allows you to invest more money into the new property acquisition.
The first thing to understand is that the real estate transaction itself must be structured as an exchange. It is not considered a sale and a purchase. The investor is required to sign an exchange agreement while also working with a qualified intermediary during the sale of the first property and the purchase of the “replacement” property. Again, you are not selling and then buying. You are exchanging one property for the other.
The intermediary holds the proceeds of the exchange until the replacement property is bought. However, the intermediary typically does not ever have to take title on the property as long as all the necessary documentation is in place.
One major stipulation of a 1031 exchange is that the new property must be of “like-kind” compared to the relinquished property. The good news here is that the definition of like-kind is fairly loose as long as it’s one type of investment property traded for another. When the exchange is set up property, you can buy and sell many different types of real estate:
- Raw Land
- Commercial Property
- Single-Family Rental Homes
- Multi-Family Homes and Complexes
Both the new and old properties must be held for investment properties. One important thing to note here is that appreciation can be considered an investment under certain circumstances, except in cases where it’s clearly a property held for personal use (primary residence, vacation home and new home construction). However, if you own and use part of the property for your residence or business while also renting out other parts of the property, you can qualify for a 1031 exchange. An example of this might be a multi-family owner who lives in one unit while renting out the others.
In addition, it must be the same taxpayer who is selling the relinquished property and purchasing the replacement property. That taxpayer can be an individual or a company, so long as the entire exchange is done under the same entity. In order to defer all the tax in a 1031 exchange, the acquired property must be equal or greater in value (including equity and debt) than the relinquished property. A 1031 exchange can still be completed if the new property is worth less than the old one, but you might only receive partial tax deferral.
A replacement property must be identified within 45 days of closing of the relinquished property. The replacement property must be properly identified based on specific criteria in order to qualify for the 1031 exchange. If it is not identified within the 45-day period, the transaction cannot be completed as a 1031 exchange. The new purchase must be completed within 180 days of the relinquished property closing. If the first property closes in the final quarter of the year, the investor will be required to file a tax return extension to ensure they get the full 180 days.
With this in mind, the investor may identify up to three properties regardless of fair market value. Or, they follow the 200% rule, which states that the investor may identify an unlimited number of properties as long as the fair market value of all properties does not exceed 200% of the relinquished property’s value.
1031 Exchanges in Aspen Real Estate
I work with a lot of real estate investors here in Aspen, so I know how great 1031 exchanges can be when done properly. I also know it’s an option that not nearly enough investors take full advantage of, so I wanted to share this information here. I hope you find it helpful.
If you are buying or selling real estate in Aspen—whether as an investment or for personal use—let me know how I can help. I am happy to answer any questions you have and get you started on the path to a successful real estate transaction. Call me at (970) 366-0891 or email me at [email protected]