Key Highlights
1031 Exchange is a Capital Gains Tax Deferment Strategy
– A great way to keep building your wealth for the future
– Can only be done on like-kind properties in a set amount of time

I was speaking with a client the other day about a home purchase in Santa Monica. He told me that he had recently sold his home in Los Angeles and I asked him if he was doing a 1031 exchange. I was surprised with his response when he asked me what a 1031 exchange was. Through my experience in real estate, I’ve found that some people don’t know their full real estate options when purchasing and selling properties. As a Realtor, I feel like it’s my duty to educate others on understanding how real estate works.

What is a 1031 Exchange?

a 1031 exchange allows a person to defer paying their capital gains tax on a property when it is sold as long as they purchase another like-kind property using the profit gained by the sale of the first property.

A 1031 Exchange (also called a Starker Exchange or LikeKind Exchange) is a capital gains tax deferment strategy for real estate property. The “1031” refers to the IRS tax code. Simply put, a 1031 exchange allows a person to defer paying their capital gains tax on a property when it is sold as long as they purchase another like-kind property using the profit gained by the sale of the first property.

Now everything I am explaining refers to mainly California Real Estate. Each state may have slightly different rules or regulations to 1031 exchanges.

Traditionally a 1031 exchange is where one property is literally swapped for another property where that owner wants your property. The reality of that though is the likelihood that the property you want is owned by someone who wants your property is extremely rare. This is why the majority of exchanges are delayed. In a delayed exchange you need a middleman who holds the cash after you sell your property and uses that cash to purchase the replacement property for you. This example of a three-party exchange is treated as a property swap.


Benefits to doing a 1031 Exchange

Nobody would consider doing this if there weren’t any inherent benefits to doing a 1031 Exchange. Here are a few reasons where you can benefit from this tax deferment option:

  1. You can build your wealth by avoiding having to pay taxes everytime you sell your property. You do this by rolling your profit into your next property purchase. You are able to keep purchasing and selling your property and deferring your capital gain tax until you decide to ultimately cash out and sell your property at which time you will only have paid your capital gains tax once.
  2.  You are able to trade properties – say your original home is worth $500,000, you are able to sell that home and use that cash to purchase 2 other properties that have a total value of $500,000 or similar.
  3. Say you’re an investor and you own a low-income and high maintenance investment property, you may exchange that high maintenance property for a low maintenance investment without needing to pay a significant amount of taxes.

4 Types of 1031 Exchanges available

  1. Delayed Exchange
    This type of 1031 exchange is the most common. A delayed exchange allows an investor to sell their investment property first and find a replacement property within a set time period
  2. Reverse Exchange
    Simply put, a reverse exchange is where you buy first and pay later. However its a bit more complex than that. This type of exchange must be an all cash purchase, the tradeoff being that most banks will not lend to you. The reason for the complexity of getting a bank loan? That’s because you can’t be on the title to the replacement and relinquished property at the same time. A solution to that would be you creating an LLC that can take title to the replacement property. Once you’re able to sell the original property you’re able to transfer the title of the replacement property into your name.
  3. Simultaneous Exchange
    A simultaneous exchange is where an owner is able to relinquish and close on a replacement property within the same day. This is what the original 1031 exchange was meant for – a direct exchange. However, this isn’t the most common. The chances of a person who owns the exact property that wants your property are quite slim.
  4. Construction/Improvement Exchange
    This type of exchange is another popular one. Say a person who sells their property and realizes that they want to purchase another home that costs less than the one they sold, what would they do? They may consider doing a construction or improvement exchange. This exchange type allows a person to use the remaining cash to build or improve on the property that they want to purchase.

Rules to doing a 1031 Exchange

1st Rule – Must be a like-kind property exchange
In order to do a 1031 exchange, you must be exchanging property that is “like-kind” This is a broad term meaning that both properties must be of “the same nature or character, even if they differ in grade or quality.” For example, you can’t exchange a car for a house, they aren’t like-kind assets. Other than that you may exchange any other type of real estate property (homes or apartment buildings, commercial or residential) for each other just as long as it’s not personal property.

2nd Rule – This must be investment or business property only
A 1031 exchange is only allowed if its for an investment or business property. You can’t exchange personal property or swap one primary residence for another primary residence.

Examples:
– If you just sold your primary residence in California, you couldn’t exchange your home for another primary residence in Florida.
– If you were to sell your single family rental property in California, you could theoretically exchange it for a commercial rental property elsewhere.

3rd Rule – Property must be greater or equal value
If you wanted to completely avoid paying any taxes on a sale of your property, the IRS requires that the net market value and equity of the property you are purchasing to be the same or greater than the property you are selling. If not, you won’t be able to defer 100% of the capital gains tax.

Example:
You have a property that is worth $500,000 and a mortgage of $250,000. In order to receive the full benefit of a 1031 exchange, your new property or properties that you purchase must have a net worth of at least $500,000 and you would have to carry over at least a $250,000 mortgage.

4th Rule: You must not receive a “Cash Boot”
You must not receive any cash from an exchange if you are looking to be completely tax-free through a 1031 exchange. Any cash you receive is taxable to the extent of a gain realized on the property exchange. You could carry a partial 1031 exchange where the new property is of lesser value than the one you sold but it will not be 100% tax-free. The “boot” refers to the amount that you will have to pay capital gains taxes on. This option is fine and is done when the seller wants to make some cash and doesn’t mind paying some taxes on it.

Disclaimer: Although I am a Los Angeles Real Estate professional, I suggest you speak with a CPA (Certified Public Accountant) about doing a 1031 exchange. 

Ashraf Spahi is a Los Angeles Real Estate professional specializing in residential properties throughout Los Angeles.

Contact me at (323) 673-0041 or Ash@VividAgent.com