If you are a recent real estate investor, you have probably heard about a lot of terminology that applies to the industry. As is the common saying, if you want to become an expert at something, you should first learn and memorize all of the acronyms and abbreviations that industry uses. This blog post will be the first in a series of blogs that are designed to educate a new real estate investor, particularly one whose investment strategy is to buy and hold.

What is a 1031 Exchange?

A 1031 exchange is an IRS tax term that allows an investor to sell an asset for another in-kind asset through an intermediary and defer paying capital gains taxes on the profits. The replacement asset(s) must be indentified within 45 days and at least one of those must close within 180 days after the original asset sold. Qualifying assets must be held for at least a year. However, the IRS looks favorably on assets that are held for at least two years prior to exchanging.

What assets qualify for in-kind asset exchange?

An in-kind asset refers to selling one class of asset and exchanging it for another of the same class. For example, an investor currently owns several small multifamily properties such as duplexes and quadraplexes.  They wish to sell all of them in order to consolidate their portfolio into one large multifamily property. They could use a 1031 Exchange to hold the profits from the small multi-family properties and apply that to the larger property.

 

Another example is that an investor currently owns land that currently used for grazing. They wish to sell the land and use the proceeds to buy a multi-family property. A 1031 Exchange is useful in this situation also. 

However, if said investor currently owns real estate and wishes to cash out of real estate in order to start a boat rental business, then they could not a use a 1031 Exchange to facilitate that. 1031 Exchanges can only be used to swap real estate with other real estate, vehicles with other vehicles, and airplanes with other airplanes.

 Photo Credit Wikimedia Commons

How to use a 1031 Exchange

1. Find a reliable and trustworthy intermediary. Title companies are a great place to start as this is a service that many offer. Another resource is to check with a local REALTOR© that specializes in investment properties. Please do your due diligence to find a reputable intermediary as there are many horror stories of fraudulent vendors!
   
   
2. Sell the original asset(s). An intermediary typically charges about $750 to facilitate the transfer of the proceeds in to an escrow account. They hold the proceeds of the sale amount in escrow account until the new properties are located. A good intermediary will also notify the IRS of the sale.
   
   
3. Notify the intermediary of the intent to locate another qualifying asset(s).
   
   
4. One or more replacement assets must be located and reported to the intermediary within 45 days after the original sells. If this limit is exceeded, then the investor is responsible for capital gains taxes on the original assets.
   
   
5. Purchase and close on the new assets. This must be done within 180 days of the original sale, or the investor is responsible for capital gains taxes from the original asset. The intermediary typically charges $250 to handle this. 
    
6. Repeat as often as needed!

Using these strategies as outlined above can help to defer the capital gains taxes indefinitely and are good strategies to use in order to maximize the available capital for investing.

If you would like to know more information about 1031 Exchanges or have any other questions about acquiring investment properties in the Austin Area, please contact me at 512-693-9297 or at jordan.gouger@kw.com