A 1031 Exchange allows you to defer all capital gains taxes if you reinvest the proceeds from an investment property in to a new investment property, or a portfolio of properties of equal or higher value, and if they maintain similar or higher loan amounts.
When you sell your interest in investment property, you may incur federal capital gains taxes and, in some states, state taxes as well. Your attorney, tax advisor or real estate professional may suggest a tax-deferred exchange under Section 1031 of the Internal Revenue Code. A tax-deferred exchange allows you to dispose of investment properties and acquire “like-kind” properties while deferring federal capital gains taxes and depreciation recapture. Most states with a capital gains tax offer a similar tax advantage. The bottom line: a tax-deferred exchange allows you to reinvest sales proceeds that would otherwise be paid to the government in taxes and can be a powerful tax-deferment strategy used by successful investors.
A 1031 exchange can allow a real estate investor to shift the focus of their investing without incurring the tax liability. For example, perhaps you are investing in properties that are low-income and thus high-maintenance. You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes. Or perhaps you want to move your investments from one location to another without the IRS knocking. The 1031 makes this possible.
When you sell an investment property, even if you weren’t the one who initially purchased, you end up on the hook to pay capital gains tax.
Frankly a 1031 Exchange should be a consideration anytime you own a property that you do not live in, and you consider selling that property.
If you’ve made some bad investments, or you just have bad luck, selling your investment can cost you more than you make.
But, if you own a rental property that is worth significantly more today than what you (or the original owner) purchased it for, you can make a killing by doing a 1031 exchange.
The big question: how do you do a 1031 exchange? Continue reading the next section to learn some tips and strategies for success!
If you have already sold the property, and the sale of that property has closed (even if the money is sitting with the Title company) it is already too late to facilitate a 1031 Exchange. Once the property has been conveyed to the buyer, you have missed the opportunity.
Note… if you are at the closing table, but you have not yet signed papers, it may still be able to work, but you need to begin taking action immediately if you are interested in doing a 1031 Exchange. A 1031 facilitator may only take 10-15 minutes to set up the exchange and get the proper documents over to your title company before you sign your documents to officially close on the sale of your property.
To do a 1031 exchange effectively, you must exchange one property for another property of similar value. In the process you avoid capital gains, at least for a while.
An investor will eventually cash out and pay taxes, but in the meantime, an investor can trade properties without incurring a sudden tax obligation. It’s an important tool for real estate investors that has become a bulls-eye for tax reform evangelists.
However, the 1031 Exchange Rules require that both the purchase price and the new loan amount be the same or higher on the replacement property.
That means that if an investor were selling a $1 Million property in San Jose that had a $650,000 loan, they would have to buy $1 Million or more of replacement property with $650,000 or more leverage.
We’ll talk more about 1031 exchange rules in section 5. First, you’ll want to know about the four types of Starker Exchanges used by real estate investors.
The delayed like-kind exchange, which is by far the most common type of exchange chosen by investors today, occurs when the exchanger relinquishes the original property before he acquires replacement property.
In other words, the property the Exchanger owns (which is called the “relinquished” property) is transferred first and the property the Exchanger wishes to exchange it for (the “replacement” property) is acquired second.
The Exchanger is responsible for marketing his property, securing a buyer, and executing a sale and purchase agreement before the delayed exchange can be initiated. Once this has occurred, the Exchanger must hire a third-party Exchange Intermediary to initiate the sale of the relinquished property and hold the proceeds from the sale in a binding trust for up to 180 days while the seller acquires a like-kind property.
Using this strategy, an investor has a maximum of 45 days to identify the replacement property and 180 days to complete the sale of their property. In addition to the numerous tax benefits, this extended timeframe is one of the reasons that the delayed exchange is so popular.
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.”
Like-Kind Property Definition: Like-Kind property is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.
A 1031 exchange is only applicable for investment or business property, not personal property. In other words, you can’t swap one primary residence for another.
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax.
For example, let’s say you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031 exchange, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property).
A taxpayer must not receive “boot” from an exchange in order for a Section 1031 exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.
An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot”.
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company (“SMLLC”), which is considered a pass-through to the member. Therefore, the SMLLC may sell the original property, and that sole member may purchase the new property in their individual name.
For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, he can purchase property in his name, and be in compliance with the 1031 code.
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates, so finding all the properties you need can be a challenge.
An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.
To qualify under a 1031 exchange it’s necessary that the replacement property be received and the exchange completed no later than 180 days after the sale of the exchanged property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier.
As you might realize, there are many rules and qualification requirements that you must comply with in order to perform a successful 1031 exchange. Too sum things up, the biggest advantage of a 1031 exchange is that you can avoid having to pay capital gains taxes on the sale of an investment property. This can be a huge benefit for real estate investors who know which markets are primed to grow next. It can also be a huge downfall for beginning investors, or those who don’t understand the changing real estate landscape. If you don’t, you risk falling victim to one the biggest disadvantages of a 1031 exchange–the reduced basis for depreciation on the replacement property.
This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. In other words, if you want to maximize the benefits of your exchange, it’s important that you choose your replacement property (or properties) wisely, investing in a market that has good potential for growth in the future.
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