1031 Exchange, Market Trends, & Tax Reform
By Jeff Cornelius - June 24, 2019
On Tuesday, June 18th, we welcomed Paul Holloway from First American Exchange Company to another successful and informative THINKtank to talk about 1031 exchanges. 1031 Exchanges can be an amazing tool for maximizing returns on your real estate investments, but, as we learned from Paul, there are lots of rules to follow in order for the IRS to bless your 1031. Below are some of the highlights of his course.
Due to the strict regulations and timelines involved, we recommend working with a 1031 specialist and Intermediary to help guide you through the process and handle the financial requirements involved. You should also check Section 1031 of the IRS tax code before buying or selling a property you would like involved in a 1031 exchange.
Top 5 Things to Know:
- Real Property: Anything that is deemed to be “real property” is eligible for a 1031 exchange: residential, commercial, industrial, even water rights attached to property. Percentages vary by city and region, but overall, about 33% of all residential property in Colorado is non-owner-occupied and therefore a potential for a 1031 exchange. Urban centers like Denver and Boulder are at 50% or higher, while suburbs like Highland Ranch and Centennial only have 17% of their residential inventory listed as non-owner-occupied.
- Investment vs. For-Sale: Property must be held for investment vs. held for sale. In general, builders or home flippers cannot execute 1031s on properties they are actively buying and selling. Also, your primary residence cannot be part of a 1031 exchange. Paul explained that you may convert a 1031 purchased property into a primary residence, but you must follow specific guidelines.
- Equal To or Greater Value: The property you intend to buy must be of equal or greater value to the property, or properties, you plan on selling as part of the 1031 exchange. Additionally, you must reinvest all equity gains from your sold properties into your purchased property - you cannot take any cash out if you want all of your proceeds to remain tax-deferred.
- Timing and Identification: Within 45 days of selling your property, you must identify up to 3 properties you are considering purchasing as part of the 1031 exchange. The IRS is very strict about timing and their deadlines include weekends and all holidays. So, 45 days is 45 days, not 45 business days. In a hot market where properties can go under contract in days or hours of being listed, its best to be under contract on the properties you intend on purchasing. On the 46th day from your sale closing, you cannot amend your list of potential 1031 properties to purchase. Special rules apply if you are attempting to purchase 4 or more properties as part of your 1031. And finally, you must close on your purchased property within 180 days of the closing date of your sold property. There are exceptions here, too. If you sold your property late in the year – say November – you must complete your 1031 by the tax filing deadline of April 15th of the following year. Most investors would file for an extension in this case, but again, it pays to work with an expert who can guide you through these exceptions.
- Same Taxpayer Rule. If John Smith sells Property A, John Smith must also buy Property B. But…guess what…surprise, there are exceptions. Generally, you cannot add a spouse or partner to your purchased property if they were not a party to the sold property.
Planning your exchange:
- Specific language needs to be in your sale and purchase contracts, so check the IRS site or your intermediary before executing either contract.
- You must leave all of your proceeds in the intermediary’s account during the 1031 process. If you remove even $1 from this account, you are putting your entire 1031 exchange in jeopardy of being denied by the IRS.
- Transaction costs – inspection fees, credit reports, appraisal fees, etc cannot be paid from sale proceeds.
Reverse Exchanges. Is it possible to buy your intended “equal-to or greater value” property before you’ve sold your current property? Yes, but it is more complicated and more expensive than standard 1031s. Intermediaries in Colorado typically charge $800-1,500 to help execute a standard 1031 exchange, but those costs can jump to $5,000 to $10,000 on reverse exchanges depending on the size of the property being purchased and complexity of the transaction. In a reverse exchange, its critical to make sure your purchase contract is assignable so you can assign it to your Intermediary and a to-be-named LLC to take possession of the purchased property while you sell your equal value or less expensive property. You are still held to the 180-day timeframe to complete the entire process.
Improvement Exchanges. It is also possible to use your tax-deffered dollars to make improvements on the replacement property. This can allow you to truly customize your investment property or build something better than what is currently on the market. The replacement property will be held by an intermediary while the improvements are made and must be of equal or greater value when deeded back to you. This is definetely one of the more complex exchanges, but it is gaining in popularity.
As you can see, while 1031s can be extremely useful in maximizing your real estate returns, there are many opportunities that missteps could jeopardize your exchange in the eyes of the IRS. It pays to do your homework and engage your intermediary before you buy or sell your exchange properties.
Invalesco hosts THINKtank events throughout the year to keep our Advisors, Investors and Development partners informed and connected to the Colorado real estate market. Our next THINKtank will cover budgeting for new builds and critical line items and is tobe held in August. To be notified of future THINKtank events, please join our mailing list by emailing info@invalescoRE.com