A 1031 Exchange refers to IRC (Internal Revenue Code) Section 1031 rules regarding the tax deferral of real estate investments.
IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment, if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment.”
A properly structured 1031 exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes, helping to facilitate potentially significant portfolio growth and increased return on investment. In order to access the full potential of the benefits of a 1031 Exchange, it is critical to have a comprehensive knowledge of the exchange process and the Section 1031 code. Utilizing a Private Wealth Advisor who works closely with CPAs can help ensure that all 1031 exchange rules are followed.
Why Consider an Exchange?
As an investment property owner, the 1031 Exchange is a powerful investment tool.
Property that is sold or transferred for gain can be subject to taxation. Those taxes can add up quickly depending on the type of property it is, how long it was owned, state taxes, capital gains, depreciation and the owner’s tax bracket. Often times recapture of prior granted depreciation is also taxed. As a property seller, you may be liable for taxes that add up to 30% or more (lookout California residents, you are probably facing a number approaching 40%).
A 1031 Exchange gives the exchanger the ability to keep all of the property’s equity for re-investment, allowing the exchanger the opportunity to acquire a new investment property (replacement property) with potentially better cash flow, less direct management responsibilities, a more desirable location and other such investment goals. One could also end up with multiple properties, multiple property types, and multiple geographic locations, improving diversification of your investment portfolio substantially.
How will I benefit from a 1031 Exchange?
In a successful completion of a 1031 exchange, you are not exempted from paying the capital gains tax, you are deferring payment on the gain until the next time you sell the newly purchased property. At that time, you can do another 1031 exchange or you will pay the combined capital gains tax that you owe from any profit you have made on both properties.
Remember that if you continue to utilize the features of 1031 for all future sales/liquidations, then you will essentially “push the tax can down the road” all the way until your death. Additionally, at death, your estate should receive a “step-up in basis” to the fair market value of the property at the time of your death. This means not only will you have never paid any capital gains or recapture taxes, but your heirs won’t pay any either!
By utilizing section 1031, not only do you avoid paying capital gains tax in the year of sale, but you are able to use the equity you would have paid in tax to purchase a larger property and potentially achieve a greater future gain.
Each investor will have a different reason for participating in an exchange of property. Here are some examples of why investors use a 1031 Exchange:
- Improved Cash Flow: Exchange real estate which is producing little or no income for an improved property that can create higher cash flow.
- Appreciation: Exchange to a geographic location where properties are appreciating faster, or exchange one type of property for another property type that could have higher appreciation potential.
- Depreciation: Exchange from a fully depreciated property into a higher valued property that can be depreciated further.
- Easier Sale: Exchange for property that is easy to sell (at a later date, of course!)
- Diversification: Exchange a large property to acquire numerous replacement properties, or exchange one type of property to acquire many different types of property for greater diversification.
- Defer the Recapture of Depreciation: Exchange to defer the recapture of depreciation. This recapture tax can easily exceed 35%!
- Capital Gains Deferral: Exchange to defer capital gains tax! By performing a 1031 exchange, a taxpayer is able to defer their capital gains taxes, and thus, has more cash available to acquire other, like-kind investment property!
The meaning of “like-kind.”
One of the most common mistakes investors make is misunderstanding the key term “like-kind.” Many investors often mistakenly believe this means they have to purchase exactly the same types of property that they are selling. This is not the case. Although debt ratios may need to be maintained, or as well can be increased if desired, most any type of real estate investment will meet the requirements of a like-kind exchange.
Property held for productive use in a trade, business or for investment may be exchanged for like-kind property. For real estate, like-kind property is widely defined as real property located in the United States and some of its territories. A single-family rental can be exchanged for a duplex, raw land for a shopping center, or an office building for apartments. Any combination will work.
Real property and personal property are not considered “like-kind” to one another by the IRS. For instance, a commercial building may not be exchanged for an airplane, a single-family rental for a licensed timeshare, or raw land for heavy construction equipment.
What are the timing Requirements for a 1031 Exchange?
You only have 45 calendar days from the close of the sale of the Relinquished Property to identify your replacement property and 180 calendar days from the close of the sale to acquire a Replacement Property. It may be difficult to find a suitable property within 45 days. 1031 exchanges must be completed within these strict time limitations with absolutely no extensions, except for federally declared disasters.
This is where the magic of accessing Delaware Statutory Trusts comes into play. There is pretty much a ready supply of DST investments available at all times, making it much easier for you to select a replacement property in the limited time you have available to you under 1031 (45 days). You can also diversify amongst multiple DSTs giving you access to a broadly diversified real estate investment portfolio; multiple properties, multiple locations, multiple property managers, multiple financing schemes. Consider this in comparison to owning one individual property yourself that you are responsible for managing and caring for, located in one location.
A Qualified Intermediary (QI) is required
The IRS requires a neutral third party, known as a qualified intermediary (QI), or accommodator, be used for facilitating a 1031 Exchange. NOTE: Silverhawk Private Wealth is not a QI, but we can assist you in identifying one for your transaction.
A qualified intermediary will provide:
- The QI has “been here before, done that!” The mechanics of exchanges through Qualified Intermediaries are easy for sellers to complete since the use of typical purchase and sale agreements with assignments to the Qualified Intermediary are used in conjunction with an exchange agreement between the Taxpayer and the Qualified Intermediary.
- The purchaser of the Relinquished Property and the seller of the Replacement Property are not inconvenienced or asked to take any of the concomitant risks that Qualified Intermediaries are in business to assume. Qualified Intermediaries do, of course, require Taxpayers to sign Indemnity and Hold Harmless agreements.
- Qualified Intermediaries are a recognized “Safe Harbor,” assuming compliance with regulations. Hence, the Taxpayer’s risk of an adverse audit result is greatly reduced.
- Taxpayers have a seasoned professional managing the 1031 exchange process and won’t have to rely on naïve and unsophisticated buyers and sellers to accomplish their exchanges.
- Since most Qualified Intermediaries are corporations, and often part of title and escrow companies already, there is little risk to the Taxpayer that his/her/its exchange will not make it to the finish line compliantly.
- Most Qualified Intermediaries offer security mechanisms that safeguard the Taxpayer’s funds during the exchange period.
What is a Reverse 1031 Exchange?
Sometimes you may end up purchasing a replacement property before you can sell the property you are relinquishing. If this occurs, you will want to consider a “reverse” 1031 Exchange. In this case, your QI must take title to either the property you are selling before you purchase the replacement property, or must take title to the replacement property.
For more information, please call Paul or Joe at Silverhawk Private Wealth. They can be reached at 480.296.0200.