1031 exchanges offer the savvy real estate investor an opportunity to improve their portfolio and, at the same time, defer capital gains taxes
With every new real estate acquisition comes the thrill of what happens next. Be it an investment property, commercial building, or a pristine plot of land in the heart of the Texas Hill Country, you can't wait to start crafting and positioning it as the next great addition to your ever-expanding portfolio.
Unfortunately, what comes next also includes the inevitable tax bill on your glimmering new purchase. Taxes are a necessary aspect of practically every single property transaction you make. Though taxes are always planned for, they can still prove to be a roadblock to maximizing a new property's full potential.
Thankfully, the IRS's tax code does offer you a level of flexibility you can tap when acquiring certain new properties: the 1031 Exchange.
Below we detail what you need to know about 1031 exchanges in Texas, including how they can boost your portfolio and which properties are eligible.
What is a 1031 exchange?
Though it sounds a bit ominous and is often considered one of the more complex property transaction schemes, the 1031 exchange is, in reality, a rather benign affair.
So named after the IRS's Internal Revenue Code Section 1031, a 1031 exchange allows an investor the opportunity to swap or exchange one investment property for another and postpone payment of capital gains tax that would otherwise be due at the time of the transaction.
As the IRS frames it:
"[A 1031 exchange] allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free."
As the IRS specifies, 1031 exchanges are referenced as like-kind exchanges, further reinforcing the need for both pieces of property in a swap to be similar to one another.
Much of the perceived complexity stems from the 1031 exchange being a highly scrutinized tax deferment, closely monitored by the IRS—so much so that third-party intermediaries are required to ensure a smooth process. But if you choose the right facilitator and know when to utilize a property exchange, the 1031 exchange can be extremely useful for your investment goals.
The basics of the 1031 exchange
The underpinnings of a 1031 exchange is a relatively simple transaction in which an investor opts to sell one property (the relinquished property), then uses the proceeds from that sale to invest in a similar or "like-kind" property of nearly equal value and physical or functional comparability (the replacement property). The reinvestment allows you to defer the capital gains taxes until later.
If no proceeds are generated from the initial property sale, there are no applicable capital gains taxes. There's no need to reinvest the funds you get back from the sale.
If you plan to sell a property with an expected return on your initial investment and want to take advantage of a potential 1031 exchange, the process is easy to understand. It does, however, feature many different moving parts.
Qualifying like-kind property
The property you plan to buy needs to be similar to the one you plan to sell. It's the singular most important aspect of the program. However, though the property values and functionality should be similar, the condition of the properties involved in the exchange does not matter.
For example, the following combinations would qualify as similar or like-kind:
- Rental property along the Gulf Coast and rental property in Fredericksburg
- Vacant land updated with a dwelling and vacant land not yet developed
- A multifamily apartment community and a commercial or retail strip center
- A hotel and a restaurant
Additionally, you can only utilize the 1031 exchange exception for property targeted for investment or use as a business. Personal residences, including your primary home or a secondary or personal vacation retreat, do not qualify for 1031 status.
The qualified intermediary
The second major factor of a 1031 exchange is using a qualified intermediary to help facilitate the transactions. Also referred to as accommodators or exchange facilitators, these specialists serve as a conduit for you, the property investor, as you navigate the nuances of the 1031 exchange process.
Arguably their most central function is holding in escrow the proceeds from the sale of an exchange's first property before releasing those funds directly to the closing agent to secure the second, like-kind property in the transaction.
But more than simply watching over the funds, the intermediary executes the 1031 exchange according to IRS guidelines, including the completion and submission of the associated documentation. Effectively serving as independent custodian of a 1031 exchange from the first listing until the exchange process is finalized, the intermediary is critical to the process — so much so that the IRS may negate the capital gains tax deferment of any exchange not facilitated by a qualified intermediary.
Within Texas, 17 dedicated qualified intermediaries are listed on the U.S. Federation of Exchange Accommodators trade group website. This is by no means an exhaustive list, and there are numerous others within the state, including the Texas Hill Country. The region includes 1031 facilitators from non-affiliated groups, independent operators, and title companies.
1031 exchange reporting
While the overall process is relatively simple to follow and execute, 1031 exchanges are heavily scrutinized property transactions. That oversight comes directly from the IRS.
Your intermediary helps guide the exchange process not just by holding your sale proceeds (and what you will ultimately purchase the new property with) in escrow. They also ensure you adhere to timelines (see below) and report the transactions to the IRS when appropriate.
That reporting includes IRS Form 8824: Like-Kind Exchanges, which covers the specific details of the exchange. Depending on the nature of the exchange, you may also be required to complete IRS Form 8949 - Sales and Other Dispositions of Capital Assets and IRS Form 4797: Sales of Business Property.
Another of the 1031 exchange's unique attributes is the timeline or timelines in which to complete the transaction. The first is a 45-day window in which to identify the replacement property for the one that you just sold. You can identify up to three properties as the potential with the stipulation that you actually close on one of them. The three properties must be designated, in writing, to the intermediary.
Then, you must close on the new replacement asset within 180 days from the sale date of the first property. Failure to meet the requisite deadlines could result in the IRS deeming any gains from your property sale taxable.
When to use a 1031 exchange
Although 1031 exchanges seem like an effective way to defer your tax burden to a later date, the structure of these deals is not for everyone. This is especially true for those who want to avoid strict timelines, use sales proceeds for new investments, or deal more directly with the IRS.
That said, exchanges prove a valuable tool for investors (and general property owners) in a handful of scenarios, including:
- Acquiring a property that features a greater future return or long term upside than a current holding
- Diversifying your portfolio
- Consolidating several properties into fewer or a single asset (popular for estate planning purposes)
- Using a single asset to expand your portfolio with up to three exchange-acquired deals (you can close on more than three, though special provisions and requirements will apply)
- Resetting depreciation and avoiding an increase in taxable income from depreciation recapture
Other types of 1031 exchanges
- Build to suit: The replacement property is either renovated or newly built, but all improvements must be completed within the 180-day time frame; anything completed after would not be included in the exchange.
- Reverse exchange: If you acquire one property before selling another, the property to be relinquished must be sold within 180 days.
There are a few more details worth knowing before exploring your own 1031 exchange deals.
Should there be leftover proceeds or cash from a completed exchange, these funds, known as "boot," can be subject to capital gains tax.
As there are no specific limitations on the number of 1031 exchanges you can transact, you should be cognizant of amassing too many at any one time. Perhaps the most crucial fact about a 1031 exchange is that the tax bill does eventually come due. Stretch yourself too thin with too many exchanges, and you could find yourself under a far heavier burden than if you'd paid the capital gains at the time of sale.
The 1031 exchange is a wonderfully unique option in your real estate investing arsenal. The timely and wise application of this strategy will give your overall investment strategies a considerable boost and you the confidence to expand your Texas Hill Country portfolio.
Looking for Texas Hill Country real estate?
It’s important that your agent has a deep understanding of the process since specific language must be added to the property contract for the buyer, seller, and title company’s acknowledgment of the intended 1032 exchange. The realtors at Reata Ranch Realty are not only knowledgeable of how 1031 exchanges work in the Lone Star State, they’re here to help you add to your collection of Central Texas investments or seek a primary or vacation home for yourself or your family. From Llano ranches to Fredericksburg homes and land for sale, allow Michele Smith and her team's years of experience and expertise to be your guide to Texas Hill Country's luxury real estate market. Contact Reata Ranch Realty today.