Also known as “Like-Kind Exchange”, a 1031 Exchange is the exchange of one real estate property for another without payment of capital gains taxes. The term “1031 Exchange” is derived from Section 1031 of the U.S. tax code.
Before starting the process in Spokane Washington, it’s important that investors understand the variety of moving parts involved in a 1031 Exchange. Here are some of the rules that investors are required to follow as per Section 1031 of the Internal Revenue Code (IRC).
- An exchange be made with a like-kind property.
- An exchange be done within a certain timeframe.
- A qualified intermediary (QI) be hired to facilitate the process.
The following is everything you need to know when it comes to carrying out a 1031 Exchange in Spokane WA.
What is Section 1031 of the Internal Revenue Code?
Basically, a 1031 Exchange is an exchange of one like-kind property for another without the need to pay capital gains tax. This can help grow your investment portfolio, as you can roll over the gains from one Spokane WA investment property to another and another.
A 1031 Exchange need to be like-kind. But the term “like-kind” has a relatively broad meaning. The following are some of the exchanges that qualify as like-kind:
- Swapping an investment apartment for raw land.
- Swapping a ranch for a rent-ready single-family home.
- Exchanging a strip mall for gas and oil royalties.
- Exchanging a condominium for an apartment complex.
- Swapping a hotel for a retail property.
- Swapping a shopping center for an industrial building.
For a property to be termed like-kind, it must either be held for business or investment purposes. For this reason, the following investment properties don’t qualify as like-kind:
- A residential home
- Partnership interests
Timelines Investors Must adhere to in a 1031 Exchange
In a delayed 1031 Exchange, which is the most common type of exchange, you’ll need to hire a qualified exchange facilitator. This qualified intermediary will facilitate the process on your behalf. It's important that you select one with professional credentials that will maintain a fidelity bond in an amount of not less than one million dollars as well as one that protects clients against losses caused by criminal acts of the facilitator.
A qualified exchange facilitator is someone who holds the proceeds of the sale of the relinquished property and uses the proceeds in acquisition of the replacement property. During this process, certain crucial timelines must be observed:
This is the amount of time that an investor has to identify a replacement property after they have sold the old one. As per 1031 Exchange rules, only a qualified intermediary can keep the proceeds of the sale in a qualified trust or a qualified escrow account.
If you receive any cash from the sale, the 1031 Exchange will fail and you’ll be liable for capital gains taxes. There are no extensions or exceptions when it comes to the 45-day identification period which includes both weekends and holidays.
According to the IRS, you can identify up to three investment properties as replacement properties. You can also identify more as long as certain valuation parameters are met.
This is the second timing rule that comes with a delayed exchange. The rule requires that an investor close on the replacement property within 180 days of selling the relinquished property.
Please note that both of the timing rules run concurrently. For instance, should you identify the replacement property 20 days later you will have 160 days left to close on that property.
What are the Tax Implications of Cash and Debt in a 1031 Exchange?
After acquisition of the replacement property, you may find that you’re left with some cash. This cash is what Section 1031 of the IRC refers to as “boot”. Since it wasn’t used in the acquisition of the replacement property, it’d be subject to capital gains tax.
Besides cash, reduction of debt is also subject to capital gains taxes under IRC. You must consider mortgage loans or other debt on the property that you relinquish.
Suppose, for instance, that you had a mortgage of $500,000 on the property you relinquished. However, on the replacement property, the mortgage is $400,000. In such a case, the $100,000 would be classified as boot and would be taxable.
What are the various types of 1031 Exchanges?
A delayed exchange isn’t the only type of 1031 Exchange that an investor can complete, here are some other types:
- Simultaneous Exchange. The exchanges are simultaneous – the selling of relinquished property and purchase of the replacement property is done on the same day. It’s the simplest type of exchange.
- Construction/Improvement Exchange. This allows an investor to use proceeds from the sale of the relinquished property to improve a property or build on land.
- Reverse Exchange. This option involves acquiring the replacement property prior to selling the relinquished property. It’s somewhat complicated than a delayed exchange.
Delayed exchanges, or deferred exchanges, are the most common types of exchanges under the IRC.
There you have it. A simplified guide to the 1031 Exchange in Spokane WA. But, a like-kind exchange can be tricky, especially in the middle of a lease agreement. That’s why it may be important to hire a professional with extensive experience to walk you every step of the process.
Windermere Property Management is an expert in the Spokane WA real estate market. With our exceptional planning and extensive experience, we’ll help you leverage the 1031 Exchange tax deferral strategy to ensure you have reached your investment goals. If you're an investment property owner in the Spokane WA area, get in touch with us to get started right away!