The 1031 Exchange is the perfect vehicle for investors looking to defer capital gains taxes while reinvesting in more profitable real property. Although the 1031 exchange ‘swaps’ investment properties only, there are additional ways in which an investor can get a major tax break. One of these ways includes having stocks, bonds, or partnership interests, in a portion of real estate.
If you’d like to explore stock or other exchange options for real estate investment properties, consult an expert in investment property who has helped numerous passive real estate investors take strides toward their financial goals.
Whether you aim to generate predictable cash flow, trade real estate, defer capital gains taxes, and/or diversify your investment portfolio, you can achieve your goals through an expert in investment properties. As long as you abide by the Internal Revenue Code, the income potential can be massive.
So, can you do a 1031 exchange through stocks? Let’s find out below…
How the 1031 Exchange Applies to Real Estate Investors
Many investment property owners are already well familiar with the 1031 exchange. However, they may not realize how the exchanging of a stock or stocks applies. It’s important to overview how the 1031 exchange involves investment property, personal property, and capital gains tax deferral before considering any partnership or stock exchange.
Generally, the 1031 exchange allows investors to swap a relinquished property for a replacement.
Understanding Like-Kind, Personal, and Real Property
Whether you swap one property for the other property or multiple properties at once, all relinquished and replacement properties must be like-kind properties. A like-kind exchange is one in which any property swapped is strictly for business or investment purposes. This must be real property, which includes permanently fixed buildings and land, and not personal property such as items or vehicles.
During a like-kind exchange, the exchange of a primary residence or vacation home, like a beach house, is generally prohibited. The relinquished and replacement assets must also be located in the same country to be part of a like-kind exchange.
All kinds of real estate may apply. For instance, one apartment property may be traded for other real estate on farmland. Quality and class typically don’t matter. You can be relinquishing and investing in commercial businesses, residential units, industrial facilities, or in some cases, vacant land/raw land. If you acquire a new property in a 1031 exchange and want to rent it, you can do this as long as you charge a fair rental value based on the market.
1031 Exchange Rules on Real Property & Investment Property
As a real estate investor, you can exchange only real property under a 1031 exchange, and it must be used for business and investment purposes. Real property refers to any parcel of land and all that is permanently fixed to it. Real property investors can enjoy the right to ownership, the right to possess, the right to sell, and the right to lease their land. However, any land or building used strictly for personal use cannot be entered into a 1031 exchange.
If you are unsure about the business, personal, or investment purposes of your property, or are confused about the extent of your ownership or the tax code that applies, consult a specialist in IRS 1031 exchange laws.
There are four types of 1031 exchanges every investor needs to understand.
- Delayed Exchange – This is the most common form. The investor relinquishes a property, takes the cash, and uses those sales proceeds when investing in the new purchase. The new property must be identified in 45 days and the complete purchase must be done in 180 days. Investors can actually identify up to three properties as long as they acquire one investment property from those three by the 180th day.
- Reverse Exchange – This is a delayed exchange in reverse. Basically, an investor must pay for the replacement property before the old property is even sold. Many investors find this risky because there is no guarantee they will get the sale of the old property in time. The standard 45-day and 180-day limits apply.
- Simultaneous Exchange – This involves owners swapping deeds at the same time. Typically, a third party or qualified intermediary (QI) will facilitate the transaction to ensure it is done correctly, honestly, and promptly.
- Improvement Exchange – Under this swap, the investor sells a property, assigns an identified replacement property to a QI, and then uses the sales proceeds to cover improvements on the replacement property held by the QI. That said, there are caveats. The new property must be “substantially the same” as before it was improved.
1031 Exchange Rules on Capital Gains Taxes and Capital Gains Tax Deferral
Many investors think that by swapping properties under Section 1031, they’ll immediately enjoy tax cuts or tax-free outcomes. Property received and sold under the exchange does not always qualify for full deferral. Depending on the market values and sales proceeds, tax liabilities may vary significantly.
For a full tax break and zero tax liability, you’ll want the replacement property to have a greater or equal value than your relinquished property. This way, you can invest all your proceeds from the sale into the new property.
Understanding the IRS Tax Laws Doesn’t Have to Be Difficult
If you’re unsure about your net equity or debt and how they apply to your exchange, consult a tax professional. You can also always contact real estate agents to determine the fair market value of your real estate before it’s up for sale.
In some cases, you cannot fully defer capital gains taxes. For instance, if you sell a property and have remaining cash, you’ll likely be paying taxes to the IRS on those sales proceeds as capital gains. Called ‘boot,’ this leftover cash or gain can be immediately taxable. You may also have to pay depreciation recapture taxes on your gain if you depreciated your property.
Also, be sure not to use cash-out refinance too closely to the 1031 swap or the IRS may assume you’re trying to take out equity. Wait at least a half year to a year. For questions about the IRS, your gain, your primary basis, or anything else tax or 1031-related, contact a seasoned 1031 tax specialist.
The 1031 Exchange for Stocks – What are the Options?
Under the Tax Cuts and Jobs Act of 2017 signed by President Donald Trump, stocks and bonds are not included in a 1031 exchange because they are not real property. Nonetheless, investors can use IRS Code Section 721. Under this section, you can put your investment real estate toward an interest in a partnership. Because you are only receiving an interest in a partnership in exchange for your property, this ‘swap’ is tax-exempt.
You can maintain your interest for 12 to 24 months before contributing it to a transaction under Section 721. This means that it’s rolled into a Real Estate Investment Trust (REIT), making it an interest in the actual REIT.
If you’d like, you can always directly invest in the REIT. However, any shares purchased will be subject to taxation. If your primary goal is to reduce taxes, you should first purchase ownership in a slice of real estate before it’s contributed to an REIT. Because you have an actual property that delivers income, and not just cash for a stock, you will be able to acquire more shares.
Overall, the IRS Code Section 721 permits investors to transfer property from a like-kind exchange for REIT shares without having to pay taxes on any capital gain. If you are at all unsure about this process, speak with a 1031 expert.
Optimizing Your 1031 Exchanges in 2023
Exchanging under Section 1031 is not always a simple process. Sometimes, you may be confused about various rules, regulations, and terms. You may wonder about the application of cash, mortgages, and other financial structures. You may be unsure as to your rights as an investor or taxpayer.
If you have stocks, bonds, mutual funds, or other assets, in addition to realty, your options are open. However, you have to be careful. This is why you should always speak with a seasoned investing specialist for guidance.
At NNN Deal Finder, we work with educated investors from all over. By targeting low-risk, high-reward reputable brands, we open up a vast network of available real estate to interested purchasers. Provide us with your information and our 1031 specialist will be in touch.