JF2122: 7 Rules of 1031 Exchange | Syndication School with Theo Hicks
1031 Exchange allows a taxpayer to defer the assessment of any capital gains tax and any related federal tax liability on the exchange of certain types of properties. This will allow you to sell a property and instead of paying taxes on the capital gains, you can delay it by investing it into another property. Theo will go over the 7 rules of the 1031 Exchange so you can have a better foundation about the 1031 exchange and can determine if its the right move for your business.
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hello, Best Ever listeners and welcome to another episode of The Syndication School series, a free resource focused on the how-tos of apartment syndication. As always, I am your host, Theo Hicks. Each week, we air two podcast episodes that focus on a specific aspect of the apartment syndication investment strategy, and for the majority of these episodes, we offer you free resources. These are free PowerPoint presentation templates, free PDF how-to guides or free Excel calculator templates that’ll help you along your apartment syndication journey. All of these free documents as well as past syndication school series can be found at syndicationschool.com. Today, we’re going to be taking a deep dive into the 1031 Exchange.
So the 1031 Exchange, according to the United States Internal Revenue Service, and if you want the exact code, it is 26 USC 1031. A 1031 Exchange allows a taxpayer to defer the assessment of any capital gains tax and any related federal tax liability on the exchange of certain types of properties. So what this means is that you can sell a property and rather than paying taxes on the capital gains, you can delay paying that tax by investing into another property.
So there are a lot of rules surrounding this, which we’re going to get into in a little bit, but a little bit of interesting history – in 1976, the federal courts allowed this 1031 Exchange code to be expanded to not only sell real estate, but also to continuously purchase within a specific timeframe with no liability assessed as that time. So it allowed you to, starting in 1979, do the 1031 Exchange that we know today. Something else that’s interesting is that before 2018 – I didn’t know this – properties listed under the 1031 code included stocks and bonds and other types of properties. So you were able to 1031 Exchange stocks and bonds. Whereas now, post 2018, the 1031 Exchange only applies to real property, which makes it great for real estate investors.
So there are seven primary aspects or seven primary rules that you must follow in order to successfully do the 1031 Exchange. So we’re gonna go over each of those in episode, but first, we’ll just go over with what the rules are and we’ll go into more detail on those rules. So the first one is that it must be like-kind property. The second rule that it is only for investment or business intentions. Third, greater or equal value of the replacement property. Four is the boot. Five is the same taxpayer rule. Six is the 45-day identification window, and then seven is the 180-day purchase window. So those are the seven rules that you’re going to want to know about when you’re doing the 1031 Exchange.
So first is the like-kind property. So the replacement property that you buy needs to be like-kind with the property that you’re selling. So if you’re selling land, you need to buy land. If you’re selling an apartment, you need to buy an apartment. So you can do a 1031 Exchange for land or anything attached to the land, but you can’t go from an apartment to land or from land to apartment; it needs to be like-kind. So you can’t just sell your apartment community and buy anything. There are certain rules on that, and for more specifics on that, you’re definitely gonna want to talk with your 1031 Exchange consultant, which we’ll talk about later on in the episode. Well, I guess we can mention it now. You typically want to do this through a consultant or I think you’re required to do it through a 1031 consultant, but most people are just going to go from apartment to apartment or maybe a single-family home to a duplex or a duplex to an apartment. So you shouldn’t have an issue with this unless you’re trying to go from land to a warehouse or something. In that case, you should have a conversation with your consultant. So number one, it must be like-kind in order to meet the requirements of the 1031 Exchange.
The second rule is only for investment or business intentions. So to meet the criteria for the 1031 Exchange, the real estate that is being sold must be utilized for investment or business purposes only. So you can’t do this with your primary residence. You can’t do this with a vacation home. It must be a property that either generates cash flow or you bought for appreciation, or was used for business purposes. So for example, you could 1031 Exchange from a property that you were using as a rental or if you bought a hair salon and you bought the place for appreciation, you’re doing your hair salon business, then you wanted to 1031 Exchange into a larger hair salon, you can do that as well, even though technically you weren’t collecting rent on the building. But overall, it must be used for investment or business purposes only. It cannot be something that you use for personal use like a primary residence or a vacation home.
The next rule is that the replacement property must be a greater or equal value. So you’re allowed to 1031 Exchange into an unlimited number of properties or a single property as long as, again, they’re like-kind and they meet other rules, but there are restrictions on the value or the total value of the properties or property purchased, and the window currently is between 95% and 200%. So if I’m 1031 exchanging a property worth $100,000, then I can exchange into one or more properties that are equal to a value of between $95,000 and $200,000. So I can’t go below that window, and I can’t go above that window. As long as I’m in that window, and again, it meets all the other requirements, then I’m allowed to do the 1031 Exchange.
Now, a good question to ask that you might be thinking of as well – if I do below 95% or if I go below 100%– so say, I sell that $100,000 property and I exchange it to a $95,000 property, what happens to that $5,000? Is that also tax-free? That goes into our next rule, which is the boot.
So whenever you don’t go into a replacement property that is equal to or greater than, then that difference is going to be called the boot and that is going to be taxable. So you don’t get that money tax-free. There are some boot offsetting provisions and other things that go into boot, but that’s the simple explanation. If you want to know more about the boot, if you plan on 1031 exchanging into a lesser value property – again, you can’t go below 95%, so it’s a pretty small window… But if that’s what you’re going to do, then make sure you have a conversation with your 1031 consultant to understand how that boot will be taxed.
The next rule is the same taxpayer rule. So it is mandatory that the person who is doing the 1031 Exchange, who is selling a property and exchanging into another property, must be the exact same person, and that is defined as the exact same tax identity. So if I buy a property under an LLC, then that is the same LLC that needs to buy the next property that is being exchanged into. If I use my personal name, I put it under my personal name, then I need to buy the other property as well. So the reason why is if the taxpayer changed their identity, then based on tax law, there would be no continuous action of tax. So it just needs to be the same entity or same individual that sold the property and buys the property.
Next is the 45-day identification rule. So the person or entity that plans to do the 1031 Exchange has 45 days from the date of the sale of the previously owned property to identify the replacement property. So this 45-day window is typically referred to as the identification period, and this process must be done in writing with the authentic signature of the taxpayers. So that is what officially finalizes the fact that you’ve identified a replacement property.
So when identifying the replacement property, here are a few things to remember. First, again, it needs to be used for business or investment purposes. It can be located anywhere in the US, and actually starting in 2005, there were certain temporary regulations that allowed people to do 1031 Exchanges in Guam, the Northern Mariana Islands, and also the US Virgin Islands. So a little 1031 trivia there.
The property must be clearly identified, needs to have a physical street address or a legal property description. Sometimes you might even need the actual specific unit addresses if you’re doing apartments, and the process of identification, you have until midnight of the 45th day to identify the property. If you purchase a property within 45 days, you actually purchase it, there is no formal identification needed. So you don’t have to do the formal signing process. You can just buy it and you’re fine. A little bit of things you want to think about whenever you’re looking at identifying that replacement property.
And then we’ve also got the final rule, which is the 180-day purchase rule. So when completing a 1031 Exchange, not only is there a window for when you have to identify the property, but there’s also a window for when you need to actually buy the property. So according to the 1031 Exchange rule, you have 180 days to purchase the property, which is six months, and this rule applies no matter what. So you have to buy a new property within 180 days in order to defer those capital gains taxes.
So there you have it; those are the seven rules that you need to know about doing a 1031 Exchange. That concludes this episode. We’ve talked about the 1031 Exchange briefly before, but we didn’t really go into that much detail on the actual steps.
So I wanted to do an episode where we went a little more detail on those steps in case you’re in the process of selling a property right now and want to know how to avoid paying a massive tax bill on all that equity created by implementing your value-add business plan. Since this is syndication school, obviously you are able to do a 1031 Exchange as an apartment syndicator, just keeping in mind that, again, the taxpayer that bought the first property needs to be the taxpayer that buys a second property. So since you’re typically doing apartment syndications through an LLC or an entity, you want to keep that in mind to make sure you’re doing the 1031 Exchange properly.
So thanks for listening. Make sure you check out some of the other syndication school episodes on how-tos of apartment syndications. Also, check out the free documents we have available, all of that is at syndicationschool.com. Thanks for listening. Have a best ever day and I’ll talk to you tomorrow.
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