The 1031 exchange was a genius idea. I’d like to meet the politician who thought that up. He’s long gone now, I’m sure, but the idea is fantastic, from a government point of view. I’m in the midst of a 1031 right now so lets delve into the benefits and risks.
The 1031 Exchange
The idea of a like-kind exchange was first put into law in 1921, according to Exeter 1031 Exchange Services (not a sponsor). Simply put, it allows a tax-payer to take the profit from the sale of one property, use it to purchase another property, and defer the tax on the profit. Keep in mind that the taxpayer is not avoiding tax, just kicking it down the road to the future. The idea is that that tax money is more valuable to the taxpayer right now than it would be in the future.
First, let’s talk nuts and bolts, then I’ll give you a few reasons I love and hate the 1031 exchange.
You first get your sale under contract, get the title company going, and then contact your 1031 exchanger of choice. They will give you a bunch of documents for you to sign, including a disclosure to the buyer that you are doing a 1031. I wouldn’t put anything about it in your purchase agreement because they might offer a lower price knowing you want to 1031. Some people do put a 1031 clause into their offer; talk to your agent first. Probably not a big deal at this point in the game, but it is when you are purchasing.
Next you close on the property and the profit goes off to the trust account as you can never handle the money yourself. You now have 45 days (calendar days, not business days) after closing to identify up to three properties you would like to purchase. You don’t want the seller to know you identified their property because you are now under the gun to purchase one. If they knew this they might raise the price knowing you are desperate to defer the tax.
You have 180 days from closing to close on your purchase. The trust money gets paid on your purchase at closing and you’ve completed your exchange. Here’s why I love and hate the 1031:
- Defer tax – You already know this one. You get to take the profit from one property and move it to another one without paying tax immediately. That tax money can be up to 20% and 1/5 is a big chunk of money that could be put to use by you rather than the tax man.
- Avoid tax – If you (and your spouse) die, the tax liability is wiped away for your heirs. You may have saved many thousands over the years in taxes and never have to pay it back.
- Accumulates tax liability – you can sell and then buy multiple times and the tax liability rides with the new property. You always have to buy something larger in value than your previous property so you won’t owe more than the property is worth but if you ever decide to cash out you may have a huge tax bill. This can lock you into feeling like you have to hold on to your property until you die.
- It’s complicated – There are very strict rules on doing an exchange. If you do it wrong, you won’t enjoy the benefit (which means you have to pay the tax). I’m using Exchange Resource Group and they have walked me through the process. There is a fee but it’s minimal. You have to sign over your property to the intermediary, which is a little disconcerting. That nice juicy check you were hoping to get? It has to go to them, at least until you purchase your new property.
- Only certain properties are allowed – you can’t buy a property for personal use. These need to be investments. You also have to do a like-kind exchange. This is pretty broad. As long as its real estate and as long as it is an investment, you can do it. I’m converting the profit from a single family house and putting it into a farm with a rental house and rental space for horses.
- You might buy something dumb – Uh oh, I just bought the farm. Literally. A farm came up for sale next to our home. We never would have considered it but for two things: It was next to our primary residence, and we had a 1031 exchange going. I’m not a farmer. I will rent it out to farmers, but I don’t know about farms. I could buy a lemon. You also have to be fast so that urgency might encourage you to make a bad decision.
I’m not an attorney or an accountant. This is general information on the 1031 and it might not be great for everyone. Talk to your expert before you start down this road. And good luck.