The 1031 exchange (26 U.S. Code 1031), otherwise known as a like-kind exchange, or Starker exchange, is one of the most important tools for a real estate investor. I’ve seen too many military members not aware of this rule.
I’ve actually talked with military members who have sold their investment properties and had no idea they could defer the capital gains through this exchange. I don’t want this to happen to anyone.
Let’s get clear on it!
When you sell real estate, Uncle Sam wants it’s cut of your profits.
There are only two ways to avoid paying the profits, or capital gains, on a real estate sale.
One exception is for homeowners who have met certain requirements with their primary residence, namely you’ve lived in the property 2 of the last 5 years (2 of the last 15 for military).
The other exception is for real estate investors, which we are focusing on with the 1031 exchange.
The 1031 exchange got its name from the section of the IRS tax code it comes from. This is the section that allows for a like-kind exchange that defers the tax liability of the sale into the next asset.
Keep in mind, the 1031 exchange, or “like-kind” exchange used to apply to items other than real estate. As of December 2017, a tax reform law that passed limits exchanges to only real estate.
You may also hear the exchange called a Starker Exchange named after T.J. Starker, who successfully sued the U.S. government in 1979.
Before that, the exchange of real estate actually had to be simultaneous. Now, you can typically have 180 days between the sale of the property and the purchase of the replacement property.
Thanks Mr. Starker!
8 CRUCIAL RULES
First, we need to understand what type of real estate can be substituted for what.
The answer to that is, almost anything that falls under real property.
Investments such as land, commercial buildings, multi-family and single family homes certainly meet this definition.
It is possible to sell three properties of any type and then exchange into one. Conversely, it is also possible to sell one properties of any type and exchange into three. These numbers can be changed as necessary.
2) NO PRIMARY RESIDENCES
The 1031 exchange is only allowed for investment or business property. You cannot use it when you sell your primary residence.
There is actually a better way to avoid capital gains on a primary residence if you meet the right criteria. If you lived in the property 2 of the last 5 years, you may qualify for a capital gains free sale.
3) MUST USE A QUALIFIED INTERMEDIARY
To successfully and legally complete a 1031 exchange, you must use a qualified intermediary. It is a legal entity that is trained and allowed to walk you through the steps of this complicated process. There are rules that say it can’t be your regular real estate agent or someone you already deal with on a regular basis.
These rules are numerous, and easy to screw up, so the qualified intermediary is key in making sure all of this goes smoothly. It’s their job to make sure this goes smoothly. Find a reputable one!
4) 45 DAY TO IDENTIFY REPLACEMENT
You have 45 days after the closing of the first property to identify up to three potential addresses of properties you are considering using as a like-kind exchange.
5) CANNOT RECEIVE THE FUNDS
This is kind of the point of using the qualified intermediary. You are not allowed to ever be in possession of any of the funds from the sale of the property and it’s transfer to the purchase of any other properties to complete the exchange. If you did receive it, it would become taxable income.
6) CANNOT RECEIVE BOOT
Boot is any surplus funds that the seller-investor may end up with throughout the 1031 exchange process.
If somehow through the purchases or sales of the properties the seller-investor ended up taking cash away from the deal, that would be known as “boot” and would be taxable at the normal capital gains rate.
Also, if for some reason, the replacement property was never purchased, and the proceeds from the first property are given to the seller-investor, that is also “boot” and will also be taxable at the normal capital gains rate. Not completing the 1031 exchange is a risk you run during this process.
7) SAME TAXPAYER
THE 1031 exchange must occur between the same taxpayer. This applies between the properties being sold and the ones replacing them.
An exception to this will be a single-member limited liability company (SMLLC) which is considered for tax purposes a pass-through entity and, in essence, the same taxpayer.
8) 180 DAYS TO PURCHASE
The replacement property must be received no later than the earlier of 180 days after the closing of exchanged property or the due date of the income tax return including extension for the tax year in which the exchanged property was sold.
COST BASIS AND DEPRECIATION TRACKING
Once your money is rolled into the new property, the depreciation schedule that you were following from the original property needs to continue on the new property. In other words, if you had already depreciated that property 10 years, you would continue from the same point with the amount of money you carried over into the new property. You don’t start over fresh on the new property.
This is not a simple task, and it is not time to have H&R block or the free guy on base keep doing your taxes for you. Pay money to have a smart real estate tax guy do it right!
1031 EXCHANGE UNTIL YOU DIE!
While most argue that with 1031 exchanges you eventually pay capital gains taxes, it is possible to avoid them, at least in your lifetime. I recommend you speak to a CPA and tax attorney about this.
If you keep 1031 exchanging a property and then you die, the cost basis of the property resets to the market value for your heirs, and they owe no capital gains taxes when they inherit it from you. For this reason, 1031 exchanges can be useful estate planning tools.
No matter what a taxpayer’s basis was at the time of their death, the heir who inherits the property receives a stepped-up basis that eliminates the gain.
This is what rich people do!
REVERSE 1031 EXCHANGE
It is possible to do a 1031 exchange in reverse.
In other words, you can buy the replacement property first, then decide which property of yours you are going to sell.
This all needs to be done within 180 days.
It requires using a qualified intermediary to create an exchange accommodator titleholder agreement. It’s not worth getting deep into here. It’s complicated, and the qualified intermediary can walk you through it if for some reason you thought that might be what you want to do.
One of the biggest benefits of real estate is the tax breaks. You need to understand all that goes into them.
Now you understand the 1031 exchange a.k.a. Starker exchange, a.k.a. like-kind exchange. This can defer, or in some cases, avoid capital gains.
This can be a key part of your wealth building strategy. Take advantage of it. Make sure you saw my article from last week on avoid capital gains on primary residences (with a special allowance for active duty).
Get out there and buy more properties. Don’t be afraid of capital gains, there’s probably a way to avoid it!
Rich on Money
Want to know how I accumulated my 20 paid-off single family homes from overseas while serving in the military? Read my Complete Guide to Real Estate Investing