So, you think you are ready to sell your property, but you don’t want to pay capital gains tax. You’ve thought about doing a 1031 exchange, but have never done one before and don’t completely understand the rules.
If this sounds like you, you’re not alone. A 1031 exchange can seem complicated at first, but with the right guidance the rules themselves are easy to follow.
In this article we’ll cover the important rules of a 1031 exchange across three categories, including:
- Value, equity and debt
- Identifying replacement properties
- Qualifying real estate interests
Value, Equity and Debt
Since a 1031 exchange’s benefit comes from its ability to help you defer paying capital gains tax on your real estate investment, it makes sense that there are rules surrounding the value, equity and debt in the transaction.
For the 1031 exchange to work as it is designed, in most cases you’ll want to purchase a property of equal or greater value as the one you are selling. This difference in value is what will allow you to grow your portfolio and “trade up,” which is usually what you are trying to do when using a 1031 exchange.
Trading into a property with a higher value is also what allows the rules surrounding your equity to work correctly. To avoid paying any capital gains tax on the transaction, you must reinvest all of the equity from the sold property into the new property. If there is equity left over that is not reinvested, that amount will be taxed.
For example, say you had $100,000 of equity in your previous property. If you contribute the full $100,000 towards the purchase of a new property, you will have avoided paying any capital gains tax. However, if for some reason you are only able to contribute $70,000, you will be taxed on the $30,000 that is left over.
Of course most real estate transactions aren’t done completely with equity, so you’ll likely also need to understand the rules surrounding debt. Similar to how it’s recommended to reinvest the same amount of equity into the transaction, you’ll also want to obtain an equal or greater amount of debt on the replacement property. The only exception to this rule is that a reduction in the amount of debt can be offset with additional equity.
For example, if the amount of debt on your original property was $200,000, you’ll need to obtain at least that amount of debt on the replacement property. If you can only obtain $150,000, you can contribute an additional $50,000 in cash to offset the difference.
Identifying Replacement Properties
If you’ve read our article on how a 1031 exchange works, you know that the identification period has strict deadlines that must be followed. In order to meet those deadlines, it’s important to understand the rules surrounding identifying replacement properties.
THREE (3) PROPERTY RULEOPERTY RULE
There are three ways to identify a replacement property, the most common way being the three-property rule. As the name suggests, this rule allows you to identify up to three properties during the identification period, regardless of their market value. Once the identification period is over, these will be the properties that you are allowed to purchase as a part of the 1031 exchange.
Another way that you might find useful is the 200% rule. This rule allows you to identify any number of properties, as long as their total fair market value (FMV) does not exceed 200% of the FMV of the property you are selling.
For example, if the value of the property you are selling is $100,000, under this rule you would be allowed to identify up to $200,000 of replacement properties. This rule is commonly preferred by investors wishing to diversify their portfolio.
When uncertain about which properties to ID, you can select several properties (with fair market values within the 200% allowance).
For those who wish to diversify their portfolios, the 200% rule is preferred.
The third method you’ll want to know is the 95% rule. Under this rule, you are allowed to identify any number of replacement properties so long as the FMV of the properties you purchase by the end of the 1031 exchange have a value of at least 95% of the FMV of all the properties you identified. For example, if the total FMV of all the properties you identified is $200,000, you must purchase at least $190,000 worth of property for the 1031 exchange to be conducted successfully. This rule is typically used when both the three property rule and the 200% rule fail to meet the investor’s needs.
Investors may have a need to identify more than three properties and more than 200% of the sales value of the relinquished property. In this case, the 95% rule is best.
1031 Exchange Insurance
For investors who are challenged with the strict 45 or 180-day timelines, our Delaware Statutory Trusts (DSTs) can close within 24 hours. We like to consider using a Delaware Statutory Trust (DST) as a 1031 exchange backup plan because there is no guarantee the investor will successfully close on the properties identified within the stated 180-day window. We always recommend identifying at least one of our Delaware Statutory Trust (DST) properties as an alternative backup option. Browse our 1031 exchange approved properties today.
Qualifying Real Estate Interests
The other important rules that you’ll want to understand before conducting a 1031 exchange have to do with the types of real estate interests that qualify for an exchange, commonly referred to as “like-kind” properties.
We’ve written a complete article on what qualifies as a “like-kind” property that goes into more detail, but the general idea is that the property you are selling must be similar in some way to the property you are buying. This doesn’t mean that the property you are selling must be identical to the one you are buying, but rather must be another form of real estate interest. For example, you could sell an office building and purchase a warehouse, or sell your mineral rights in exchange for a rental home.
It’s in your best interest to understand what does and does not qualify under the “like-kind” property rule, so we recommend doing your research and consulting with an expert if you have any questions.
Things to Note:
We hope this article gave you a good overview of the most important rules surrounding a 1031 exchange. Although a 1031 exchange is a slightly more complicated process than a traditional property purchase, the benefits typically outweigh the extra effort required.
Be sure to read our other articles to continue learning about the 1031 exchange process. If you have any questions or would like to begin the 1031 exchange process for your property, contact one of our experts at Marzo Capital Group and we’d be happy to assist.
Full Disclaimer Copyright 2007-2020 Marzo Capital Group. All rights reserved.
The contents of this communication: (i) do not constitute an offer of securities or a solicitation of an offer to buy securities, (ii) offers can be made only by the confidential Private Placement Memorandum (the “PPM”) which is available upon request, (iii) do not and cannot replace the PPM and is qualified in its entirety by the PPM, and (iv) may not be relied upon in making an investment decision related to any investment offering by the respective issuer, or any affiliate, or partner thereof ("Issuer"). All potential investors must read the PPM and no person may invest without acknowledging receipt and complete review of the PPM. With respect to the “targeted” goals and performance levels outlined herein, these do not constitute a promise of performance, nor is there any assurance that the investment objectives of any program will be attained. These “targeted” factors are based upon reasonable assumptions more fully outlined in the Offering Documents/ PPM. Consult the PPM for investment conditions, risk factors, minimum requirements, fees and expenses and other pertinent information with respect to any investment. These investment opportunities have not been registered under the Securities Act of 1933 and are being offered pursuant to an exemption therefrom and from applicable state securities laws. Past performance are no guarantee of future results. All information is subject to change. You should always consult a tax professional prior to investing. Investment offerings and investment decisions may only be made on the basis of a confidential private placement memorandum issued by Issuer, or one of its partner/issuers. Issuer does not warrant the accuracy or completeness of the information contained herein. Thank you for your cooperation.
Securities offered through Emerson Equity, LLC Member: FINRA, SIPC (CRD#: 130032/SEC#: 801-71293,8-66296). Only available in states where Emerson Equity, LLC is registered. Emerson Equity, LLC is not affiliated with any other entities identified in this communication.
For more information, read our Disclosures & Disclaimers