1031 Exchanges save on taxes
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Tax Deferred 1031 Exchange
What is a 1031 Exchange?
The 1031 exchange can be a great strategy to increase your cash flow by deferring taxes and accruing appreciation of a real estate asset. It has been used by savvy real estate investors for decades. Through a properly executed 1031 exchange, you can legally delay paying taxes on investment gains when you sell a qualified property and keep that money working for you instead of paying the government to spend frivolously.
The premise is simple: Whenever you sell business or investment property for a gain, you generally have to pay tax on the gain at the time of the sale. IRC Section 1031 provides an exception and has been in the code since the Revenue Act of 1921. You can postpone paying tax on the gain if you reinvest it in a similar, “like-kind” property.
Disclaimer: I am not a tax consultant or tax attorney and do not know your particular financial situation. Please consult your accountant and/or attorney before attempting to implement this strategy because there are certain rules you must follow. The topics in this article should not be considered tax advice.
1031 Exchange Calculator
Use the link below to calculate your potential tax savings by doing a 1031 exchange and then proceed to the deal room to view available offerings.
The six things to know before doing a 1031 Exchange
A 1031 exchange is somewhat similar to a traditional tax-deferred IRA or 401(k) retirement plan. Transactions made within your retirement plan — selling the shares of a fund, for example — are not a taxable event. The capital gains that would otherwise be taxable are deferred when you sell assets within your retirement plan. You’re exchanging one income-producing asset for another. You don’t pay taxes until you withdraw cash from a qualified retirement plan. The same principle holds true for tax-deferred exchanges of real estate investments. As long as the money continues to be reinvested in similar real estate assets, the capital gains tax can be deferred.
Many taxpaying entities can qualify for a 1031 exchange. Individuals, C corporations, S corporations, partnerships, LLCs and trusts are the primary ones. It is most often used in connection with sale of real estate property. But some exchanges of personal property can qualify under Section 1031 too. Certain types of property are specifically excluded from Section 1031 treatment, including:
- Inventory or stock in trade
- Stocks, bonds or notes
- Partnership interests
- Certificates of trust
The big idea behind the 1031 exchange is that since the taxpayer is merely exchanging one property for another of “like-kind,” there is nothing received by the taxpayer that can be used to pay taxes. In addition, the taxpayer has a continuity of investment by replacing the old property. All gain is still locked up in the exchanged property, so no gain or loss is “recognized” or claimed for income tax purposes.
The 1031 financial transactions, starting with the proceeds from the sale of the old property, must go through a custodian or what’s termed a “qualified intermediary.”
The intermediary holds all the profits from the sale and then disburses those monies at the closing of the exchanged property (or sometimes for fees associated with acquiring the new property). To get the full tax deferral, the entire amount of the cash proceeds from the original sale has to be reinvested toward purchasing the new real estate property. Any cash retained by you from the sale of the old property is taxable income called boot.
At the close of the relinquished property sale, the proceeds are sent by the title company handling the closing directly to the qualified intermediary. That person or entity holds the funds until the transaction for the replacement property acquisition is ready to close. Then the proceeds from the sale of the relinquished property are deposited by the qualified intermediary to purchase the replacement property. After the acquisition of the replacement property closes, the qualified intermediary delivers the property to the taxpayer, all without the taxpayer ever having what the IRS calls “constructive receipt” of the funds.
The intermediary is “qualified” according to the IRS because he/she is an independent party with the sole purpose being to facilitate the exchange process. You cannot act as your own facilitator. And your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee, or anyone who has worked for you in those capacities within the previous two years) cannot act as your intermediary.
IRC Section 1031 allows you to postpone paying tax on gains only if you reinvest the proceeds in a similar or “like-kind” property. Like-kind property is a property of the same nature, character, or class. Asset class, quality or grade doesn’t matter. Most real estate will be like-kind to other real estates. But there are exceptions. For example, real estate property located within the U.S. is not like-kind to property outside of the U.S.
There are other rules related to “like-kind.” Here are two important ones:
- The total purchase price of the replacement “like-kind” property must be equal to or greater than the total net sales price of the relinquished property.
- All the equity received from the sale of the relinquished property must be used to acquire the replacement, “like-kind” property.
Taxpayers who hold real estate as inventory or who purchase real estate for resale, are considered “dealers.” These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying properties. Property for personal use will not be eligible for Section 1031.
There are several important dates to complete a 1031 exchange. A like-kind exchange does not have to be a simultaneous swap of properties. But you must meet two-time limits, or the entire gain will be taxable. These limits cannot be extended for any circumstance (except in the case of presidentially declared disasters).
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties that you propose or intend to buy. The identification must be in writing, signed by you, and delivered to a person involved in the exchange, such as a qualified intermediary. Giving notice to your attorney, real estate agent, accountant, or similar persons acting on your behalf in any part of the transactions is not sufficient.
During this Identification Period, replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address, or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second time limit is referred to as the Exchange Period. The replacement property must be received, and the exchange completed no later than 180 days after the sale of the exchanged property.
So to complete a 1031 exchange, a taxpayer must identify the replacement property within 45 days of closing and acquire the replacement property within 180 days of closing the sale of the original property.
Both the relinquished property you sell and the replacement property you buy must be held for one of two purposes:
- For active and productive use in a trade or business
- As an investment that is either:
- Income-generating, such as a rental property.
- It is expected to increase in value, such as vacant land that you intend to sell later for a profit.
Property used primarily for personal use, such as your primary residence does not qualify for like-kind exchange treatment. A vacation property may be eligible for a 1031 exchange, but there are specific rules to follow. For a minimum of one year before and after the exchange:
- The property must be rented for a minimum of two weeks to a non-relative.
- You can rent to a relative if it is their primary residence and is rented at a fair market price.
- The property must be used personally for only two weeks or 10% of the time rented.
- You can maintain the property for an unlimited amount of time, but documentation must be kept for these activities.
- Report income from the property on Schedule E of your tax return.
The 1031 exchange is not intended for investors who are in the business of buying distressed properties, rehabbing them, and reselling them.
As mentioned, taxpayers who hold real estate as inventory or who purchase real estate for resale are considered “dealers.” These properties are not eligible for Section 1031 treatment. However, if a taxpayer is a dealer and also an investor, he or she can use Section 1031 on qualifying properties. Again, you always need to remember that “personal use” property is not eligible for Section 1031.
When you use a 1031 exchange, you are deferring the tax because you are exchanging one similar asset for another. While that helps your current cash flow, your gain will eventually be taxed if you sell the property without doing an exchange.
“Swap until you Drop” is a popular expression by savy real estate entrepreneurs. There’s no time limit for holding the property. You can defer taxes as long as you still own the property. And you can do another 1031 exchange on the same property down the road and again defer the taxes, as long as you’re exchanging like-kind properties and following all the rules. The great thing about this strategy is if you use this strategy your entire lifetime, your heirs get a step-up in basis at death and all of the capital gains are wiped away. If you need some capital throughout the years, you can take out the “boot” and only pay tax on that portion. We feel that every real estate owner that qualifies should execute a 1031 exchange and keep the money working for them. That is why we went to great lengths to build a virtual, convenient online platform to properly implement your 1031 exchange and collaborate with all of your financial professionals in one location. Please call us if you have any questions.
In a 1031 Exchange, abiding by the IRS Timeline is Crucial
Failure to comply with the deadlines and all the rules will likely result in a failed exchange. If you take control of cash or other proceeds before the exchange is complete, the entire transaction of like-kind exchange treatment is disqualified and all gain is immediately taxable.
A Stress-Free Way to Do a 1031 Exchange
Holsell is the only online real estate marketplace that offers real estate investors to network with real estate professionals, source properties, buy/sale real estate, implement a 1031 exchange all done on the most advanced and secure technology available with the use of blockchain and smart contracts and tokenization.
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If you are undecided whether or not you want to do a property to property exchange or a property to DST exchange, please call us for guidance.
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