The 1031 Exchange Opportunity is a tax rule that allows people to “swap” one bit of real estate (used for investment purposes) for another with little or no taxes to pay at the time of the exchange. All of this depends on whether the IRS believes there was no capital gain for that property.

Here are some things you should know about the 1031 Exchange.

You Can Only Swap Business or Investment-Specific Real Estate

Hoping you can switch your house for another? Unless it is a secondary or investment property used for income, it is not possible. The 1031 Exchange Opportunity isn’t allowed in cases of personal real estate, though in some cases you are able to swap other property as long as it falls under a “like exchange” via the IRS’s definition.

Brandon Turner from Bigger Pockets explains another benefit of the 1031 exchange for investors:

“[A 1031 exchange] can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible.”

Personal property can include artwork and paintings, livestock, aircraft and aircraft parts such as engines, certain licenses (such as television/radio broadcasting licenses or taxi medallions), trademarks and a handful of other items.

The 1031 exchange opportunity works in four ways:

• Simultaneous Exchange – this is where you can swap or complete a two-party trade. The two parties involved “swap” deeds. Or is three parties are involved in the exchange, an “accomodating party” facilitates the swap for the exchanger. Or perform an exchange using a qualified intermediary who structures the whole exchange process.
• Delayed Exchange – Most common use of the 1031 exchange; the relinquished property is sold, followed by the purchase of the desired property. A third party Exchange Intermediary hold the proceeds of the sale in a binding trust for a maximum of 180 days while the exchangor works on purchasing the new property.
• Reverse Exchange – Also called a “forward exchange”, the reverse exchange is when you buy the new property first and pay later. However, this type of 1031 exchange requires cash and his hard for which to obtain a bank loan. If you are unable to acquire funds within 180 of the purchase, the exchange is forfeit.
• Construction/ Improvement Exchange – Improvements can be made to the replacement property using equity from the exchange sale.

Sometimes you want to swap out your property but there is nothing that is close enough or that you want at the time of the swap. In the meantime, you are stuck with the expenses related to your property, which can be a sinkhole that drags you down more and more with each passing year.

In this case, you would do a delayed exchange. It works by having a middleman who holds the profits gained from selling your property. They will then purchase the new property for you when you are ready. Within 45 days of this exchange, you have to submit a written document stating the intended replacement property. Then, you will have up to 6 months to close on the property you’re buying.

Once the exchange has gone through, any remaining cash will be taxed as a partial sale. So many people who use this delayed exchange will seek out a property that is as close to the amount of original sale as possible to avoid this tax.

Interested in learning more? Contact Jensen and Company.