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4 Types of 1031 Tax Exchanges: Delayed, Reverse, Simultaneous & Improvement Exchanges

Types of 1031 Exchanges

A 1031 exchange can be an excellent investment in a vacation rental or a vacation home. Named for IRS Section 1031, this form of like-kind property investment is a way to defer capital gains taxes.

The various types of 1031 exchanges have strict rules. For example, the money involved in a 1031 sale must be held in escrow, and the buyer can never have those funds in their possession.

Knowing the ins and outs of 1031 exchanges can be a highly effective method of utilizing tax breaks for real estate investment. Here are the four types to know about before investing in a 1031 tax exchange property.

Delayed Exchange

This is the most common type of 1031 exchange, where a third-party intermediary typically holds the funds for up to six months (180 days). There are two phases in a delayed 1031 exchange: the relinquishment and the acquisition.

The relinquishment phase is when the buyer relinquishes a property they've already mortgaged. The property is sold to someone else, and a third-party intermediary receives the payment for the property in escrow. The sale contract must have a clause stating it is a 1031 exchange. There are no time limits on the relinquishment phase.

The clock is ticking once the acquisition phase begins, however. The exchanger typically has 45 days to identify a 1031 exchange property for sale. It must be a like-kind property in the eyes of the IRS for the deal to be valid. The IRS does not grant extensions, and the buyer must purchase the new property within 180 days to defer capital gains on the purchase.

Reverse Exchange

In a reverse 1031 exchange, the process described above is reversed. The buyer purchases a new property, and then they have 180 days to sell their existing property. The two properties must be of similar value and size to qualify as a 1031 exchange with the IRS.

Reverse exchanges can be a helpful type of 1031 if the buyer owns multiple investment properties and wants to exchange one of them. The buyer has to select an Exchange Accommodation Titleholder (EAT) at the beginning of the process. The EAT agrees to hold the title of the newly purchased property for the duration of the sale process.

Once the EAT takes possession of the new property's title, the buyer has 45 days to identify the investment property they wish to exchange and 180 days to complete the transaction. Like the delayed exchange, all funds in a reverse exchange must be held in escrow by a third party. If the buyer takes possession of the funds at any time, their capital gains cannot be deferred by the IRS. Once the relinquished property is sold, the EAT transfers the title of the new property to the buyer.

Simultaneous Exchange

In Reverse 1031 Exchanges The Buyer Purchases the New Home First

A simultaneous exchange used to be the only way to do an exchange until the 1970s. The buyer and seller basically "swap" properties in a two-party trade exchange. The main advantage of this type of exchange is that a Qualified Intermediary (QI) is unnecessary, and the two investors don't need third-party involvement.

Many tax experts advise against using a simultaneous 1031 exchange. While it is still legal and valid, tax laws were upgraded in the 1980s to allow other types of easier 1031s.

It can be complicated to meet the requirements of a simultaneous exchange. For example, both investors must have like-kind properties in which the equity and debt match. The timing also has to work out perfectly—both investors must want to exchange properties simultaneously.

Investors can, however, still take advantage of a QI's services for a simultaneous exchange. A fee is applied from the QI and added to the total exchange price, but this is nominal compared to the expertise added to the process.

Improvement Exchange

As its name suggests, an improvement exchange involves improving the property to be exchanged. It can also apply to building an entirely new property from scratch. The same IRS 1031 deadlines apply—the improvements or construction of the new property must take place within 180 days for the sale to qualify.

The 180-day deadline can make it challenging to meet the like-kind property requirements. For example, an existing home is far more valuable than construction materials and the labor to assemble them. Pre-paying the labor and materials does not qualify for an improvement exchange for tax deferral—prepayments become taxable once the deadline is not met.

An improvement exchange's sales and purchase clauses must contain legal statements that the improvements are contingent on 1031 exchange status. Once the upgrades are complete, they must make the acquisition property equal to or greater in value than the relinquished property. Once the closing occurs in an improvement exchange, an EAT becomes the property owner until the promised improvements are made within the 180-day time limit.

1031 Exchanges For Investors

Investing in 1031 exchange properties can be a smart way for someone to grow their real estate portfolio while deferring capital gains taxes. The IRS deadlines are the most critical parts to consider. If the 45- or 180-day deadlines are not met, the investor then owes capital gains taxes on the sale. Acquiring the help of a real estate professional can be a good way to navigate the complexities of 1031 exchanges.

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