The Land Up Learning Series

If you’re brand new to Central Texas real estate or you have just started dipping your toes into real estate investing, you may not be familiar with Internal Revenue Service IRC Section 1031, or more simply, a 1031 exchange. The exchange, or one of its many other monikers including a like-kind exchange, LKE, Starker Trust, or tax deferred exchange isn’t exactly self explanatory by just the name, but it is a popular tool used by seasoned pros to maximize profits and something all potential investors should know about.

What is a 1031 Exchange in Texas?

A 1031 exchange allows real estate investors to sell (or “swap”) a property and buy another that is of the same nature without incurring the capital gains tax that you would typically see with a profit on just a regular sale. Because a 1031 exchange defers these taxes to be paid at a later date, you are able to reinvest that money immediately into one or multiple properties of equal or greater value. Central Texas property values are the highest they’ve been in history so that deferred tax amount is nothing to shake a stick at.

Here’s an example:

Let’s say Cactus Sid owns a small apartment complex – called The Prickly Apartments. He’s been itching to invest in a new property and decided to sell his current complex to help pay for the new one. His broker discovers a great, equivalent (like-kind) listing called Land Up Living.

Now if Cactus Sid just went ahead and sold The Prickly Apartments for a $100k profit without a 1031 exchange, he would have to pay $15K (15%) in capital gains tax at the end of the year. He would then have $85K left to invest in the new complex.

By leveraging a 1031 exchange, he could instead use the entire $100k profit to buy Land Up Living, in lieu of giving Uncle Sam $15k.

Note: On December 31st, 2021 a new policy change limited the amount of taxes that can be deferred on capital gains to $500,000 ($1 million if married).

What Are the Requirements for a 1031 Exchange in Texas?

In order for a property to qualify for a 1031 exchange, it must be used in a trade/business or held for investment. The property cannot be of personal use. Both properties must be of similar nature (like-kind) and the replacement property value must equal to or exceed the selling price of the relinquished property. Let’s review some terms you’ll want to know if you’re considering a 1031 exchange.

What is a relinquished property?

The relinquished property is the one being sold in the 1031 exchange. What is the new property?

What is a replacement property?

The replacement property is the one being purchased in the 1031 exchange. You can purchase multiple replacement properties as long as the value does not exceed 200% of the relinquished property.

Qualified Intermediary and Tax Deferral

You must hire a qualified intermediary to hold the funds from the exchange during the 180 day period until you have purchased the replacement property. If you receive the funds from the relinquished property then you will be subject to capital gains, thus not taking advantage of the tax deferral benefits of a 1031 exchange.

What are the deadlines for a 1031 Exchange?

When executing a 1031 exchange there are several deadlines an exchanger must adhere to in order to qualify for tax deferment.

Purchase Deadline

One extremely important element of successfully executing a 1031 exchange in Texas is adhering to the strict 180-day rule. When swapping a property under this IRS code, the taxpayer must complete the entire transaction within a 180 day period, otherwise, the gain will be included in their taxable income. The 180 day period starts once the sale of the relinquished property has been completed. The closing date is not included in this 180 day period. 

In addition, the seller also only has 45 days after the transfer of their relinquished property has closed to identify a potential replacement property or properties. The seller identifies the replacement property in writing to the qualified intermediary for confirmation.

IRS Reporting Deadline

You, the real estate investor, must report the exchange to the IRS on your federal income tax return for the tax year that you sold the relinquished property. You must also acquire the replacement property before you file your federal income tax return, if not then you will need to file an extension.

A lot of information can be found in the Internal Revenue Service’s (IRS) code Section 1031, after which the exchange is named. However, the best resource is someone who can walk you through the process. At Land Up, our Texas Land Specialists can do just that and guide you through the complexities of a 1031 exchange on a step-by-step basis. No matter what resources you end up using, learning about this wealth building tool can only help you be better informed as you make your way through the world of real estate investing.

Check out our commercial real estate listings for opportunities to use the 1031 exchange program.

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