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If you’re new to real estate investing, you have probably heard of a 1031 tax exchange. It’s a great way to sell an investment property without taking a tax hit on the profits.
That can be a big help if you bought low and sell high. You can leverage this to upgrade to a bigger, better investment property.
With all investments, there comes a bit of risk. In the case of real estate investing, you can experience a failed 1031 exchange.
While this may seem like the worst thing to happen to a real estate investor, you’ll be happy to know that all may not be lost. You may still be able to reap tax benefits from a failed 1031 exchange.
Read on to learn more about 1031 exchanges, why they may fail, and the potential tax benefits from a failed 1031.
What is a 1031 Exchange?
Let’s start off with the basics. A 1031 Exchange is a way to defer taxes on capital gains made on a real estate investment. The way you defer those taxes is to roll the profits of the investment over into another property.
1031 exchanges are named after the IRS tax code, section 1031. This is the section that essentially governs these exchanges.
According to the IRS, you have to exchange that they call “like for like” properties. These properties must have a business or investment purpose.
You can’t buy a home that you use as your primary residence, sell it for a profit, then buy a much bigger home without paying capital gains.
This is a highly simplified description of how the 1031 exchange works. You have a business or investment property to sell, whether it’s your first investment property or your seventh. You sell it, at a profit. That profit doesn’t go to you, but rather a qualified intermediary.
The qualified intermediary holds on to the profits and helps you finalize the 1031 exchange. You find a new property to purchase and you use the profits of your initial property to purchase the new property.
1031 Tax Exchange Timelines
The success or failure of a 1031 exchange hinges largely on timing. The IRS has certain guidelines and rules in place to ensure that you and other investors don’t take advantage of the capital gains deferment.
In other words, you can’t legally sell a property for a healthy profit and then wait 10 years to buy your next property. The whole process is done pretty quickly.
As soon as you sell your investment property, you only have 45 days to identify a property as replacement property. The value of the replacement property has the same or greater value as your investment property.
The purchase of the replacement property has to be fully completed by 180 days after the sale of your investment property. In reality, you have about a month to identify your property and 6 months to close it.
You’ll also want to note that these are actual calendar days, not business days.
Here’s another wrench in the timeline. If tax-day falls during your 180-day cycle, you have to either complete the transaction by then or file an extension.
For example, let’s say you purchase a property on October 17th or later. Since tax-day will happen prior to the 180 days after the sale of your investment property, you have to file an extension or complete the purchase by then to qualify.
What happens if you don’t meet these deadlines, even miss one by a day? That will result in a failed 1031 exchange. The proceeds of the sale of your investment property will be sent to you by the qualified intermediary. Once the funds are in your hands, you’ll need to pay taxes on them.
Tax Benefits of a Failed 1031 Exchange
There’s light at the end of the dark shadow cast by a failed 1031 exchange. You may be able to create a partial 1031 exchange.
This would allow you to defer the capital gains into the next tax year, giving you extra time to absorb the tax hit.
You can also use an installment sale method to defer your capital gains as well. These are complex methods to defer your taxes, and you can learn more about them here.
At the end of the day, you want to make sure that you have the right team around you to guide you on the 1031 exchange and how you can make sure that you’re covered in a successful or failed 1031 exchange.
You’ll need to find a good qualified intermediary to work with as well as a tax attorney. A real estate broker and escrow officer should be a part of your real estate team as well. Each of these team members brings specialized knowledge to ensure that your investments pay off.
1031 Exchanges Offer a Lot of Advantages
When you’re looking to leverage your money and make it work for you, you want to look at every opportunity possible. A 1031 exchange is a smart way to leverage your business or investment property sale and upgrade to a new one.
In order to avoid a failed 1031 exchange, you need to understand the timing of the exchange and the implications of not meeting the timelines in time.
If you happen to have a failed 1031 exchange, it may not be the end of the world. You may still be able to enjoy some tax benefits, even though you can’t defer the capital gains on the sale of your investment.
Do you want to know more about how you can make your money work for you? Take a look at this article about the different types of investments to grow your money.
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