Investors in Southern California’s real estate market have seen a marked increase in property appreciation over the last decade. Those looking to upgrade or swap properties through the sale of existing assets within their portfolio may be faced with a large capital gains tax bill. Luckily, through the 1031 Exchange program, investors have the option of deferring their capital gains by rolling them over into a new property.
What is a 1031?
A 1031 Exchange allows owners to defer the capital gains accrued from the sale of an investment property by transferring their profits to a new “like-kind” property.
Once the property is sold, the individual must have the funds transferred to a qualified intermediary. This qualified intermediary, or QI, receives the proceeds of the sale and holds them in escrow until they are applied to the purchase of the replacement property. Any money directly received by the seller from the sale is subject to capital gains taxes.
Owners have 45 days from the sale to identify no more than 3 “like-kind” properties, and then an additional 135 days to close on at least one (180 days after relinquished property sale). Fortunately for investors, the “like-kind” designation applied by the IRS is a misnomer; any real estate can be swapped for other real estate, as long as it is held for investment purposes. For example, a rental property in Laguna Beach can be swapped for a cattle ranch in Montana, provided it meets the IRS guidelines.
What Qualifies as an Investment Property?
To qualify for a 1031 exchange, the transaction must involve investment properties. While the rules can be open to interpretation, they generally include apartments, industrial properties, or any property held for productive business use. A house can qualify for a 1031 exchange if it meets the IRS’s safe harbor rules.
The safe harbor guidelines state that a house qualifies as an investment property if:
Reverse 1031 Exchanges
In the competitive housing market of 2021, most investors who spot a property they want don’t have time on their side if they want to conduct a 1031 exchange. With the low inventory currently available, the investor’s replacement property will have almost certainly sold by the time they've listed and sold their property. This is where the benefit of a reverse 1031 exchange comes into play.
A reverse 1031 exchange is exactly as the name suggests: once an investor purchases a property, they have 45 days to identify a property they already own that they wish to relinquish. They then have an additional 135 days to sell that property (180 total days after replacement purchase). While there’s the obvious drawback that the investor must provide the replacement property funding without the proceeds of a sale, this 180-day window allows them the time to attract the highest dollar offers on their property.
1031 Exchanges: The Bottom Line
1031 exchanges, when executed correctly, are a powerful wealth-building tool allowing real estate investors to indefinitely defer taxes on their capital gains, increasing their buying power with every exchange made. As with all potential tax questions, the complexities of a 1031 exchange require the help of a tax professional or qualified intermediary.