Some real estate investors believe it’s easier to beg for forgiveness than to ask for permission. While there may be some cases where that’s true, when you’re dealing with the IRS your pleas for forgiveness are very likely to fall on deaf ears.
Part of the reason for this is that tax laws in the U.S. shower real estate investors with benefits that can’t be found in any other type of investment asset. Dual revenue streams from rental cash flow and long-term property appreciation, deducting operating and business expenses from net income, and deferring the payment of capital gains tax are just three of many examples.
In exchange for all of the advantages of investing in real estate, the IRS expects you to play by the rules, especially when it comes to following 1031 exchange timelines.
Building Wealth With a 1031 Exchange
The IRS helps real estate investors build wealth by allowing the deferred payment of capital gains tax with a 1031 exchange. Here’s a quick overview of the benefits of conducting a Section 1031 tax-deferred exchange:
- When you sell an investment property and replace it with another federal and state capital gains taxes are deferred
- Recaptured depreciation taxes are also deferred
- A 1031 exchange is similar to having an interest free loan over an indefinite period of time
- Use your additional capital to generate more cash flow, diversify your investment portfolio, or boost your depreciation for tax strategy purposes
1031 Exchange Timelines
When you conduct a 1031 exchange there are two timelines that run concurrently:1. 45 day identification period
You only have 45 days from the day the sale closes on your relinquished property to identify one or more replacement properties. For example, if your escrow closes on October 1st you must identify at least one replacement property by November 15th (with the countdown beginning the day after your close of escrow).
Your replacement property does not need to be under contract on the 45th day. Instead, the QI (qualified intermediary) you’ve selected to facilitate your 1031 exchange will provide you with a form used to finalize the identification period.
If the identification form is not received by midnight on the 45th day of your identification period, the tax-deferred exchange automatically terminates and the funds from the sale of your relinquished property are forwarded to you and capital gains tax will be due and payable that same tax year.2. 180 day exchange period
You must also close escrow on your replacement property within 180 days from the closing of the sale of your relinquished property. This means that if your sale closed on October 1st, you must purchase and close escrow on one or more replacement properties by March 30th of the following year (again, with the 180-day countdown beginning the day after your close of escrow for your relinquished property).
In this example, your 1031 exchange is beginning in once tax year but potentially won’t be completed until after a new tax year begins. When this occurs, you’ll need to file an extension for your federal income tax return in order to receive your full 180 days. Otherwise, the exchange will end on the date your tax return is due.
However, there’s no rule that says you have to wait the entire 180 days to purchase your replacement property.
In fact, many real estate investors who have mastered the art of conducting a 1031 exchange end up buying their replacement property even before the 45-day identification period ends. In real estate markets where good deals are hard to find, oftentimes the faster you can close on the sale the better.
When and Where to Find Replacement Property
How is it that some rental property investors are able to close so quickly on the purchase of their replacement property in a tax-deferred exchange? The answer is that they plan well in advance.
There’s no rule that says you have to wait 180 days to close. And, there’s also no rule that says you can’t start looking for replacement properties even before the clock starts ticking on your 45-day identification period.
If you don’t get a jump-start on your search for a replacement property, you’ll run the very real risk of finding yourself on the wrong side of the negotiating table, especially if the seller knows the time is running out on your 1031 identification period. Nearly every real estate broker who works with investment property can cite at least one time a desperate buyer called with only a few days left to find a replacement property.
To avoid backing yourself into a corner, you can use the Roofstock Investment Property Marketplace. It’s the perfect way to monitor different real estate markets across the U.S. for turnkey single-family houses and multifamily property perfect for a 1031 tax-deferred exchange.
If you’re conducting a larger tax-deferred exchange, you can take advantage of the Roofstock 1031 Exchange program to have an expert help build you a portfolio of properties.
For example, many commercial real estate investors today are struggling to find tenants for retail or office space. Instead of going down with what could be a sinking ship, they’re opting to sell their multi-million dollar commercial property and invest in the relative safety and security created by the steady cash flow of residential rental property.
New 1031 Timelines With COVID-19
Through a series of proactive measures including Internal Revenue Bulletin 2020-23, the IRS has provided exchange relief for from the 45-day identification period and 180-day exchange period deadlines for investors currently transacting a 1031 exchange.
Real estate investors whose 45-day or 180-day periods expire after April 1st and before July 15th have until July 15th to complete the identification or finalize the exchange. The IRS recognizes that the turmoil created by COVID-19 is creating an unexpected burden for the completion of tax-deferred exchanges.
Conducting adequate due diligence and rental property inspections has become nearly impossible in many markets with stay-at-home orders in force. These new identification and exchange period deadlines allow real estate investors to push forward the identification and purchase of replacement property.
Other Rules to Know About a 1031 Exchange
In addition to the 45-day identification period and 180-day exchange period, there are several other rules to know about properly conducting a Section 1031 tax-deferred exchange:
Three main types of 1031 exchanges
- Delayed 1031 exchange: most common type of 1031 exchange, with the relinquished property being sold first followed by one or more replacement properties identified within 45 days and purchased within 180 days.
- Reverse 1031 exchange: opposite of a traditional delayed 1031 exchange, with the replacement property purchased before the relinquished property is sold.
- Build-to-suit 1031 exchange: used for ground-up development or property requiring a significant amount of repair and updating.
General rules of any 1031 tax-deferred exchange
All types of 1031 tax-deferred exchanges have the same general rules:
- Same taxpayer: name on the title of the relinquished and replacement properties must be identical because the IRS considers a tax-deferred exchange to be a continuation of ownership.
- Like-kind property: must be of a similar nature but not necessarily the same grade or quality, such as exchange commercial real estate or raw land for turnkey residential rental property.
- Investment real estate: held for business or investment purposes, which is why a personal residence (in most cases) and fix-and-flip real estate does not qualify for 1031 tax-deferred exchange us.
- Greater or equal value: replacement property must have the same or greater market value and the same amount of debt as the relinquished property.
- U.S. real estate: relinquished investment property in the U.S. must be replaced with property located in the U.S., although relinquished real estate in foreign countries can be replaced with like-kind real estate in another country.
- Taxable boot: any money directly received by the real estate investor is called “boot” and is subject to capital gains tax.
Steps to defer 100% of capital gains tax
Be sure to follow these steps of a 1031 exchange to ensure that any capital gains tax owed is completely deferred:
- Both the relinquished and replacement property must be like-kind.
- Business or investment use of the real estate is required.
- Replacement property must be of equal or greater value compared to the replacement property, and carry at least the same amount of debt.
- Boot can not be received by the investor, otherwise the funds are subject to capital gains tax.
- Name on the title of the relinquished property and the replacement property must be the same, because the IRS considers property in a 1031 exchange to be a continuation of ownership, even though the real estate is different.
- Replacement property must be identified within 45-days of the closing of escrow for the relinquished property.
- Replacement property must be purchased within 180-days of the closing of escrow for the relinquished property.
A 1031 tax-deferred exchange is named after Section 1031 of the Internal Revenue Code. Any real estate investor who holds property for business or investment use can relinquish one property and replace it with another like-kind property, and completely defer the payment of any capital gains tax.
In exchange for this unique tax benefit that only real estate offers, investors must strictly adhere to the 1031 exchange timelines:
- 45-day identification period from time the relinquished property is sold to find one or more like-kind replacement properties
- 180-day exchange period from the time the relinquished property is sold to close on the purchase of one more more like-kind replacement properties