The section 1031 tax-deferred exchange lets you sell real estate and defer your capital gain and Section 1250 depreciation taxes. While there are many reasons to invest in real estate — especially Scottsdale real estate — the 1031 Exchange is one of the best ones. By using exchanges the right way, you can potentially keep your equity rolling over in perpetuity without ever having Uncle Sam take a piece of it. However, there are a number of rules that you have to follow, and it’s important to understand them and to work with a team of professionals who can help keep you on the right side of these rules.
Replacement, Relinquished, Upleg, Downleg and Boot
For a 1031 exchange to work, you have to go from owning property to owning property. The IRS requires you to sell your “relinquished” property — also known as a downleg — and close on the purchase of a new “replacement” property relatively quickly, which means that you will want to have your Scottsdale realtors ready to help you buy quickly as possible. Furthermore, you can’t have any more cash or any less debt. If any extra money comes out of the transaction, it is referred to as boot (think of pirate’s booty, instead of footwear!), and that boot is taxable. In other words, the 1031 exchange isn’t a way for you to take cash out of your real estate (at least, not directly).
To avoid boot, your new “upleg” property has to take all of the cash that comes out of your “downleg” property. It also has to have the same or higher mortgage balance. Imagine that you invest in real estate and end up with a $2 million piece of Scottsdale real estate. You have a $900,000 mortgage balance and $1.1 million in cash equity. To perfect your exchange, you have to buy a property that costs at least $2 million. If you, however, put $600,000 down and get a $1.4 million mortgage, you would take $500,000 of cash out, which would be boot. If you buy a $1.8 million dollar property, put in your $1.1 million of cash and take out a $700,000 mortgage, you’d owe tax on the $200,000 of lower mortgage balance. However, you could buy a $3 million property, put $1.1 million down and take out a $1.9 million mortgage and owe no tax.
The next rule to keep in mind is that you have to sell your property and buy “like-kind” property. Luckily, the IRS defines like-kind relatively liberally. Investment real estate in the United States is like-kind to all other Investment real estate. An apartment building in Scottsdale is like kind to another apartment building in Scottsdale. It’s also like-kind to a retail center in Scottsdale, an apartment building in New York City or a piece of raw land in Alaska.
As you can imagine, the IRS won’t let you defer taxes without imposing some rules on the process. The idea behind a 1031 exchange is that you are able to defer taxes because you’re keeping your money in property. You sell property, and you buy more property, and you have to do it quickly.
The IRS applies two time frames to the 1031 exchange process. First, you have 45 days from the closing of the relinquished (downleg) property to identify what you will be buying. There are rules for how many properties you can identify (which we will define below), but, basically, you make a list of what you might buy, and file it with a third party. Then, you and your Scottsdale realtors have a total of 180 days from the close of your downleg’s sale to close on the purchase of your upleg. If you miss either deadline, the entire transaction becomes taxable.
The IRS further complicates the process by limiting how many properties you can identify as potential uplegs in the 1031 exchange progress. The most commonly used rule is the “three property rule.” Under that rule, you can identify any three properties that you want, and all that you have to do is purchase one, two or three of them. It’s okay to list two pieces of Scottsdale real estate and a third deal in Tucson, and buy that deal in Tucson, but you can’t buy anything else.
In certain circumstances, you might want to use one of these other two rules, as well.
- The 200% rule lets you list as many properties as you want as long as their fair market value isn’t more than twice the value of the property you’re selling.
- The 95% rule lets you list as many properties as you want as long as you buy at least 95% of the total value of the properties that you identify.
The Right Professionals
For a 1031 exchange to work, you also have to have the right team. Your Scottsdale realtors need to make sure that the agreement for the sale of your downleg property has the right language to let you do a 1031 exchange. In addition, all of the money has to pass through a third party called a qualified intermediary (QI), since the proceeds from the sale can’t touch your hands or they will be considered boot. You need to have your QI in place before you begin your exchange so that any funds received (including pass-through deposits!) can go to their account instead of yours. Of course, it’s always a good idea to have legal and accounting experts on your team as well.
Tax-Deferred, Not Tax Free
Keep in mind that a 1031 Exchange isn’t a tax-free transaction. It’s a tax-deferred one. What this means is that you carry the basis from your downleg property into your upleg property. For example, imagine that you exchange from a $2 million property into a $3 million one. Now, imagine that your tax basis in the $2 million property is $700,000 because you’ve owned it for a while. If you sold it, you’d have to pay capital gains or recapture tax on that $1.3 million profit. When you do a 1031 Exchange, though, you simply carry that basis forward. This means that the $3 million property ends up with a tax basis of $1.7 million. The new $1 million in value is new basis, while the original $2 million carries its original $700,000 basis. If you sell that $3 million property, you’d then have to pay capital gains tax on it.
What makes the 1031 Exchange such a magical way to invest in real estate is that you can keep doing it in perpetuity. So, when your $3 million property is worth $4.5 million, you can exchange it into a bigger property without paying capital gains taxes. You can theoretically keep doing this forever, or until you die. At that point, your heirs inherit the property and get a stepped-up basis. This means that, over the long term, you can use the 1031 Exchange to eliminate capital gains taxes for your estate while deferring them for yourself.
This scratches the surface of the 1031 Exchange and its complexity. Talk with tax, legal, accounting and real estate professionals for specific guidance as to how you can leverage this powerful tax strategy tool to achieve your real estate investing goals.