What Is the Most Common Type of 1031 Exchange?
In the US, a 1031 exchange is a tax break for real estate investors to reinvest into another investment property without bearing capital gains tax. This kind of swap can be used for a wide range of properties that come under the exchange category and includes mineral rights.
While the conditions for the 1031 exchange are pretty standard, there are different types of 1031 exchange, depending on how it’s carried out. In this article, we’ll discuss these types and determine which is the most common.
We’ll also look at what kinds of properties are commonly used in a 1031 exchange.
What Is 1031 Exchange?
A 1031 exchange, according to Section 1031 of the Internal Revenue Code, allows an individual to sell their investment property and acquire another similar property without having to pay any taxes on the capital gains from the relinquished property.
Properties sold and bought for the purpose of taking advantage of this tax break have to be similar. However, certain properties, such as vacation, are not eligible for this tax advantage.
As such, there’s no limit to the number of times an investor can take advantage of the 1031 exchange. However, if they cash out of an investment property and fail to buy a replacement property for it, they will be liable for paying capital gains tax.
Also, all the proceedings from the sale of the investment property must go into buying the new property for it to qualify as a 1031 exchange.
The period between selling an investment property and buying another to replace it is officially 180 days. However, the exact time may differ for certain types of 1031 exchanges. The way this typically works is that the investor sells their property and keeps the money in escrow until they find and buy the replacement property within the 180-day period.
A 1031 exchange is a viable way to increase the value of your investment over time and defer tax payments until you finally cash out and walk away with a larger profit.
Types of 1031 Exchange
There are four different types of 1031 exchange that mainly differ based on the timeline of selling and buying investment properties.
In a simultaneous exchange, the property swap occurs on the same day. In other words, the investor sells their investment property and buys another similar one in its place on the same day.
The proceeds from the sale are immediately used for securing the second investment property, which is documented.
In a deferred 1031 exchange, the investor sells their investment property first and then uses the 180-day period to identify and secure their next purchase. Technically, they have 45 days (of the 180 days) to identify and designate the replacement property. Then, the remaining 180 days can be used to finalize the purchase by moving the money from the escrow account.
In a reverse 1031 exchange, the investor first buys the replacement property and uses the 180-day period from that date to sell the first investment property. Once they have sold the initial property, they get reimbursed for the replacement property they bought and avoid any capital gains taxes.
In this type of 1031 exchange, the investor buys the replacement property first and makes improvements before selling the initial investment property they possess. In this case, the investor has up to 12 months from the date of the purchase of the property to be improved to complete the improvement work and sell the relinquished property.
This type of exchange allows the investors to construct or improve the replacement property exactly how they want and use the 1031 exchange to their advantage.
What Is the Most Common Type of 1031 Exchange?
The most common type of 1031 exchange is deferred exchange, in which the replacement property is bought first, and then the relinquished property is sold. This is because most investors find this option convenient and safe.
Not every investor may have the funds immediately available to buy a replacement property first and then sell the relinquished property to get their money reimbursed. So, the reverse exchange is less common.
Similarly, a simultaneous exchange is less common, as it typically happens when the investor sells and buys property from the same entity (a literal property swap).
Deferred exchange offers a decent window of 180 days to complete the transaction by finding and purchasing a replacement property. The money is safely put in escrow until the purchase of the replacement property.
What Is the Most Common Type of Property Used in 1031 Exchange?
There isn’t any official data from the government on the types of properties used for the 1031 exchange. However, residential and commercial investment properties are commonly used for deferring capital gains tax by leveraging Section 1031.
Remember that residential properties only qualify for 1031 exchange if they are income-generating (rental income).
1031 exchange is popular in the real estate world, as it allows investors to defer capital gains taxes and use what they would have to pay in taxes to buy a better, more valuable property. However, residential and commercial properties aren’t the only types of properties eligible for 1031 exchange.
Here are some of the other types of properties used in 1031 exchanges:
- Agriculture property
- Conservation property
- Oil, gas, and other mineral rights
- Timberland property
- International real estate
A deferred exchange is the most common type of 1031 exchange, which follows a 180-day period from the date the relinquished investment property is sold. Other relatively less common types of 1031 exchanges are reverse and simultaneous exchanges.
The properties in the exchange have to be like-kind. Although there’s no definition for like-kind, the gist is that they have to be of the same category (residential of residential, commercial for commercial, or mineral for mineral).
A 1031 exchange is a favorable tool for real estate investors to increase the value of their investment over time, especially if they don’t have the funds to supplement their investment.