What's a 1031 exchange, and why is it so popular among wealthy real estate buyers?

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Sometimes, it seems as if there are as many real estate jargon terms out there as there are actual apartments. In Bricktionary, we decode them, one buzzword at a time.

Admittedly, real estate tax codes (or tax codes in general, for that matter) aren't exactly known for inciting passion. But in real estate circles, a code known as the 1031 exchange isn't just well-known, it's downright beloved. "This is the method wealthy families use to build wealth and pass it down through generations," says Jerry Feeney, an attorney who works extensively with 1031 exchanges. "You don't want to have to pay the tax man every time you have a capital gain."

It works like this: Under section 1031 of the IRC code, when you sell an investment property—say, a rental unit—you're able to defer payment of capital gains taxes if you turn around and re-invest the proceeds in a similar or "like kind" asset within a certain time frame. In other words, if you sell an investment property then use those profits to buy another investment property quickly enough, you can put off paying taxes on them. And if you keep doing this process indefinitely, you can avoid paying taxes altogether. "You don’t have to settle up with the IRS on all the deferred gain when you die, because now your estate is just taxed as an estate," Feeney explains. "Most people just keep doing this over time, and then their estate gets a freebie when they die."

Of course, as with most freebies in life, this potential perk comes with plenty of strings—and red tape—attached. First, note the term investment property in the definition here. This means you can only pull off a 1031 with some sort of income-producing property (as opposed to your personal home or primary residence), though the definitions are otherwise loose. "If you sell residential, you can buy commercial, and vice versa," says Corcoran's Tamir Shemesh. 

"The key term here is that the property was used for (or can be used for) "productive use in business, trade or investment," explains Feeney, so even plots of land or a farm would theoretically qualify. So though many may take 'like kind' to mean what's bought has to be same type of property, that's not quite true, adds attorney Neil Garfinkel. "It’s same use, the use here being as an investment property. It can’t be a personal property used for personal residence—property held primarily for personal use doesn't qualify." It's possible to use the 1031 exchange when selling a vacation property, but the rules for this are tricky—most likely, you'll need to have rented it out (instead of vacationed in it) for at least six months in order to qualify, as Forbes points out. 

There are also strict rules and regulations as far as what happens to your money in between the sale of your former property and the closing on the next one. In between the sale of your old property and the closing on the new one, you need to place your profits with what's known as a "qualified intermediary," usually your real estate attorney. (Most real estate attorneys should be able to handle this kind of transaction, notes James Cox of Compass, who adds that if necessary, a good broker should also be able to recommend a trustworthy lawyer. "People who work in this part of the business have very strong partnerships for these kinds of things. For protection, we always have these transactions adminstered through an attorney.") "The biggest mistake people make here is that they close on the sale, put the money into their own account, then try to do an exchange," explains Feeney. "The minute you take what's known as 'constructive control' over the funds, the game's over."

Arguably the biggest snag with 1031s, however, is the tight time frame required to get one done. In order to comply with the rules, you have to identify a potential property to buy within 45 days of the sale. "The simple rule is that you identify three properties you might intend to buy, then you purchase at least one," says Feeney. The next deadline is that you have to actually close on the sale of your replacement property within 180 days of the sale, which Cox notes can be tricky if you're trying to use a 1031 exchange to buy in new construction buildings, where delays in construction, the delivery timeline, and the status of the Certificate of Occupancy are all common. This 180-day rule also adds an added headache if you decide not to go through with your new purchase. "If you do identify within 45 days and don't buy, as the qualified intermediary, I can't refund you your profits from the original sale before the 180 day period is up," says Feeney. 

As if all that weren't enough, there's one last little technicality to keep in mind here. The 1031 code actually says that you have either 180 days from the closing of your sale, or until the filing date of your tax return of the previous year to close on your new property, whichever comes first. This can cause problems if you sold your first property in the previous year, then filed your tax return before finalizing the deal on your next place, says Feeney. (He's also got an explainer of this issue on his blog.)  "Let's say you sold your former property in December, then were very efficient and filed your tax return for the prior year on January 2nd," he explains. "You've just blown your exchange inadvertently," making January 2nd your purchase deadline. "Instead, you should go on extension until you've closed on the next sale," he says. "This really only happens when you're closing on the first property towards the end of the year."

Wonky and a little bit head-spinning? Undoubtedly. But if you're looking to get into the investment property game, the 1031 is an essential strategy to have under your belt.


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