I recently attended a seminar on 1031 exchanges, as I frequently work with buyers and sellers who own rental properties in one capacity or another. The Internal Revenue Code Section 1031 allows investors to reinvest proceeds from the sale of one investment property into another similar property while deferring capital gains that would otherwise be due on the sale.
A 1031 exchange is an excellent option to have if you’re looking to move up to a bigger and better property down the line, and want to build your wealth in the process.
However, you need to be aware of the fundamentals before you can reap the benefits. Here are the four simple guidelines for exchanges, as per the Asset Exchange Company in San Francisco:
1. The properties involved must be held for “productive use in trade, business or investment” and must be like-kind. You can sell your four rental units on Haight Street and reinvest the proceeds into a six-unit rental property on Lake Street. But you can’t sell that Haight building and go buy a single-family house for yourself.
2. You have to complete the exchange in 180 days. The timeline begins when you close escrow on your “relinquished” property. There are no exceptions to this timeline.
3. You must identify your next property purchase within 45 days. After you close escrow on your relinquished property, you have 45 days to identify your replacement property. You have to identify all properties in writing, with a clear description. And there are two IRS rules for identifying replacement property. The first is the Three Property Rule, which allows for identification of any three properties, anywhere in the United States. The second is the 200% Rule, which is an option for identifying more than three properties. With this rule, you can identify four or more properties, but their combined value can’t exceed 200% of the property sold.
4. To defer 100% of the capital gains tax liability, you must meet two requirements. The first is that you have to reinvest all the cash that was generated from the sale of your relinquished property. And the new property must be equal or greater in value to the property sold. So you can’t use part of the money, or transfer any or all of the money into your own bank account. Once you touch it, you knock out the ability to do the exchange.
As you can imagine, these four points are the tip of the iceberg. There are all sorts of buying and selling situations, and it’s important to consult with a 1031 exchange consultant, as well as your CPA and attorney before making any moves. I have a great team in place if you’d like to explore your options, so feel free to contact me at 415.823.4656 / firstname.lastname@example.org.