Many people think that a 1031 Exchange of real estate can only occur through the process of a delayed exchange. However, there are actually four common methods for real estate exchanges that allow investors to transfer the equity from one investment property towards the acquisition of another, without paying any capital gains tax. Work with your qualified intermediary to determine which of these 1031 Exchanges for real estate are right for your situation.
1. Delayed Exchange
The most common type of 1031 Exchange for real estate is what’s known as the delayed exchange. In a delayed exchange, investors can sell their current property before they have decided on a replacement property to purchase. Funds from the sale of your investment property must be transferred to a Qualified Intermediary directly from the sale escrow. You are not allowed to take control of the funds since this would void the exchange. .The Qualified Intermediary holds your funds pending your instructions to transfer the funds to purchase replacement income properties. You have up to 45 days from the close of your escrow to formally choose which replacement property you would like to purchase. This timeline includes weekends and holidays and must be strictly observed to preserve your ability to complete a successful exchange.
You then have up to 180 days from the close of the sale of your relinquished property to finalize your 1031 Exchange and close on the replacement property.
2. Simultaneous Exchange
The original and oldest type of 1031 Exchange for real estate is the simultaneous exchange. It is the simplest 1031 Exchange because it involves a direct exchange of investment properties between two property owners. Two property owners complete this exchange by swapping property ownership. This means they exchange the deeds, documents, and other assets required for a transfer of ownership, but no money changes hands during this process. Simultaneous exchanges, because of their straightforward nature, often do not require the assistance of a Qualified Intermediary.
The caveat to this exchange is that it can be difficult to pull off if you and another owner are swapping properties that lie in different states or cities. If you do consider a simultaneous exchange, you should be careful that you do it safely, so you aren’t taken advantage of during the exchange.
3. Improvement Exchange
Also known as a build-to-suit exchange, an improvement exchange is a very useful 1031 Exchange for real estate. An improvement exchange occurs when you find a replacement property that isn’t quite considered “like-kind” in value but could be with some renovations or improvements. An improvement exchange allows investors 180 days to make improvements on the replacement property, so the property can qualify as “like-kind” and you can defer any capital gains taxes on your acquisition.
There are often requirements when it comes to improvements on a replacement property, such as:
- Any construction on the replacement property must follow specific guidelines that have been included in the purchase contract.
- Construction improvements made to the property have to be approved by the exchanger before funds are dispersed.
- The exchanger specifies the alterations and improvements to the replacement property.
- Any improvements to the replacement property that are not completed within the 180-day timeframe will not count towards the value of the property, and you may be eligible for capital gains taxes.
- Replacement property improvements must be made to standing structures on the property and must be completed before the 180-day time is up.
Essentially, in an improvement exchange, you are trying to raise the value of your replacement property to offset any gains you incurred on your relinquished property. This is to defer taxes and keep more of your funds in investments. To accomplish this, any improvements you make to the replacement property must render that property of equal or greater worth than your previous investment.
4. Reverse Exchange
The most complex 1031 Exchange for real estate is the reverse exchange. In this exchange, an investor can purchase a replacement property and then sell the current property, completing the exchange in reverse. To correctly complete a reverse mortgage, an investor must complete the transaction with the assistance of a qualified intermediary, because they are not permitted to be in possession of both properties simultaneously.
Some important things to know about reverse exchanges are:
- Deed transfer taxes can complicate the process in some areas
- You cannot own both of your properties at the same time—this is where your qualified intermediary can help.
- Specific sales clauses with your current mortgage holder might make a reverse exchange difficult.
- If can be hard to account for the equity that must be transferred from the relinquished property to the newly acquired property.
While a reverse 1031 Exchange for real estate might sound like a strange situation, it is not uncommon. It mostly happens when an investor has found a replacement property they want to purchase but have not been successful in selling the current property in their possession. It’s also important to note that the time requirements are the same for reverse exchanges as they are for delayed exchanges.
Get Expert Advice on Your 1031 Exchange for Real Estate
There are times when a 1031 Exchange for real estate may not be the best course of action or may not even be possible. Some examples include:
- If you are planning to resell the acquired income property within two years of purchasing it
- If you are purchasing or relinquishing a personal property that is a primary residence
- If you planning to use a 1031 Exchange for business or personal property (no longer allowed per the 2017 Tax Reform)
In these instances, the advice of a professional, Qualified Intermediary is invaluable in determining the best course of action. If you need more guidance on your real estate transactions, First Guardian Group can refer you to Qualified Intermediaries with extensive experience. We have over 16 years of experience working with rental property owners and know how to help you make your investments work for you. Contact the professionals at First Guardian Group at 408 392-8822 or via email at info@FirstGuardianGroup.com for more information and to start making the most of your investments today.