A 1031 Exchange is a tax-deferred real estate transaction that “swaps” one investment property with another investment property under very strict IRS rules for the timeline and deadlines that structure the transaction.
Recently, stay-at-home orders suspended in-person showings of properties, making it tough to identify a replacement property in a timely manner. This adds pressure on an Exchangor of real estate, who may have previously entered into an agreement to meet the date deadlines.
When no extensions for deadlines granted last week, The National Association of REALTORS® (NAR) lobbied, and as of this week, deadline extensions have been granted for exchangers already in an Exchange Agreement.
Remember, as with all issues dealing with COVID-19, changes can occur daily. Be sure to consult your REALTOR® and tax professional for any recent updates.
What is a 1031 Exchange?
A 1031 Exchange is a transaction in which the IRS allows you to sell a real estate investment and replace it with another, without paying capital gains tax on the gain of the first property at the time of sale.
If you own investment real estate and want to continue to climb the investment ladder, the 1031 Exchange allows you to continue your investment in real estate, while deferring taxes on any gain, so that you can climb faster.
This tax concept allows you to keep trading up without having to write a check to the government each time. Sometimes these exchanges are called “tax free” but they are actually tax deferred. Tax is finally paid when you no longer want to be a real estate investor and are ready to cash out. To qualify for a 1031 Exchange there are seven basic requirements. Requirements two through seven are unaffected by coronavirus restrictions, but the rule most affected is rule No. 1.
General Rules for a 1031 Exchange
1. The current rule reads that upon closing the sale of the first property, the owner has 45 days to locate the exchange property and 180 days to close on it. Therefore, it is wise to talk with your CPA and your REALTOR® before selling and closing on your property. If 45 days after the closing of the sale of your old property you don’t have an exchange property selected, your exchange will be disallowed, and tax will be due. Those 45 days can pass very quickly.
2. The “Like Kind” rule of section 1031 of the code states that the properties exchanged must be “like kind.” This simply means that the investment must continue in real estate. For example, if you own vacant land, you can exchange it for an improved income-producing property such as an apartment building or an office building. It doesn’t have to be a land-for-land exchange.
3. Must be qualifying property. Qualifying property is property held for investment or used in a taxpayer’s trade or business.
4. Any “boot” received will be taxable. Boot is any property which is not “like kind”. If the seller desires some cash or debt reduction, this is okay as long the seller realizes some tax will be due. You don’t want to receive any boot if you want the transaction to be 100% tax deferred.
5. A rule of thumb to defer taxes is to always replace the exchange property with one of equal or greater value and debt.
6. You should bring cash to the closing of the exchange property to cover charges, which are not transaction costs, such as utility escrows, rent pro-rations, etc.
7. An Exchange Intermediary must be used to hold the exchange funds from the closing of the old property. In the typical exchange you will be selling a property, which you have been holding for investment. According to the IRS rules you cannot touch the money that comes from the closing of your former property. You need to hire what is called an exchange intermediary. The intermediary will charge a fee for completing the exchange agreement and all the necessary paperwork. The intermediary will hold your cash proceeds until you are ready to close on the replacement investment property.
1031 Exchange Dates Extension
The National Association of REALTORS® (NAR) announced that the IRS has ruled that investors involved in a 1031 Exchange who need to either identify or close on a property between April 1 and July 15 will now have until July 15. This assumes that either of those dates fall between April 1 and July 15. But if an investor now has until July 15 to identify the property, the original 180-day closing date would likely remain since it falls outside the affected date ranges. If an investor is closing on the old property on June 1, and has 45 days to identify replacement property, the identification deadline is still July 15.
Due to the unknown nature of the length of time of the no in-person showings and stay-at-home coronavirus rulings, these deadlines could change again.
Be sure to consult your Realtor® and a tax professional to see if there are changes relative to your personal situation.
For more information, see the IRS Notice 2020-23 at irs.gov/pub/irs-drop/n-20-23.pdf
By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail DuaneDuggan@boulderco.com, call 303.441.5611 or visit BoulderPropertyNetwork.com.