1031 Tax Deferred Exchange

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“Knowing about the 1031 tax-deferred exchange is essential if you own an investment property and want to sell it and buy another. The owner of an investment property may defer capital gains tax by selling it and purchasing like-kind property through this procedure. Here are some critical points to know if you’re considering starting a section 1031 exchange, including rules, concepts, and benefits.”

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1031 Tax Deferred Exchange

Consult your legal, tax, and financial advisers for the most suitable tax deferral or exclusion strategy for your specific circumstances. To assist you in understanding the fundamental rules and requirements of 1031 Exchanges. This article provides a brief overview of 1031 Exchanges. For more details about Section 1031 Tax Deferred Exchanges, please read an Introduction to Section 1031 Tax Deferred Exchanges.


1031 Exchange – What Is It?

Section 1031 of the Internal Revenue Code gives the name to a 1031 exchange. A tax exemption program lets you avoid paying tax if you sell your investment property. And also invest the proceeds within a certain period in another property or properties of the same type and value.

By doing so, investors can defer capital gains taxes from the sale of a property and invest the proceeds into another, commonly called “trading up.”


Here is an example:

For example, an investor buys a property for $1,000,000 in 2015 and then sells it in 2020 for $1,750,000, earning a capital gain of $750,000. In this case, the investor must pay tax on the $750,000 capital gain from the sale. The investor may defer paying taxes on the gain by investing the sale proceeds into another property through a 1031 exchange.


1031 Exchanges: Why You Should Use Them

A tax-deferred 1031 exchange may make sense for you as an investor for a variety of reasons, including:

  • You may be looking for a property with better return prospects. Or that you wish to diversify your assets.
  • Investing in real estate may lead you to look for a managed property rather than managing your own.
  • If you are planning an estate, for example, you might want to combine several properties into one or divide a single property into several parts.
  • Below, you will find instructions on how to reset the depreciation clock.


The tax benefits

A 1031 exchange has the primary advantage of deferring capital gains tax. Allowing you to invest in a replacement property with more capital. Through a 1031 exchange, you can postpone capital gains tax until you can buy another property.

By purchasing a replacement property or properties, you defer paying capital gains taxes by selling one property and deferring the payment of capital gains taxes. Instead of paying out about a third of your equity in taxes, you can keep the money working for you.


Like-Kind” Properties: What Are They?

The tax code explicitly mentions “like-kind” exchanges when discussing a 1031 exchange. The term frequently appears when discussing a 1031 exchange. Yet, it is perhaps the most misunderstood phrase in real estate.

The term “like-kind” is often seen as being real estate-specific. The term “like-kind” is less specific in this section than in other sections.

Whether it is an investment or commercial property, you can exchange it for one that serves the same purpose. Owners of residential rentals paying 4.5% or even negative cash flow raw land can upgrade to triple net leased investment-grade commercial buildings that pay 6% in return.


As an example, let’s consider the following:

In Nashville, a couple owned a rental property that generated $1,700 in income each month. In addition to taxes, insurance, water, and garbage fees, there was spending from this revenue. As a result of painting and replacing the carpets, the couple had to pay less than $1,400 per month in income.

Their husband managed the property and tenants, and the wife kept the books. The couple owns a regional bank and a dollar store after utilizing the power of a 1031 Exchange. The couple receives $2,100 each month from both properties. Guaranteed by two of the most secure corporations in the country – deposited directly into their bank account.

Their passive income stream has been created in perpetuity due to this 1031 transition. This increased net monthly revenue by 50% without the hassle of property management.


Depreciation Reset Ability

Suppose your asset deteriorates due to wear and tear, aging, or other structural obsolescence. You can write off “depreciation” to compensate for it. The IRS recognizes 27.5 years as the appropriate period for depreciation for investment properties. Your CPA may suggest another acceptable method).

In other words, your “improvements” can be deducted from ordinary taxable income every year for 27.5 years when you divide them by 27.5. Because of depreciation, you might be able to reduce your income taxes.

You’ll pay hefty capital gains taxes if you have gains when you sell an investment property. Additionally, accumulated depreciation recapture remains taxed at a 25% federal rate, with varying results at the state level. If you sufficiently complete your 1031 deferred exchange, you won’t owe any taxes at the time of sale. Your CPA may reset the depreciable amount of your investment property to a higher value in a 1031 deferred exchange to make you more tax-efficient.


Expansion of new markets and portfolio diversification

You can take advantage of one of real estate’s best advantages, the diversification of risk, if you invest in a growing market with a lot of potential. Like-kind exchanges can take place within state lines. Your investment could pay off in the long run if you enter the door early on an up-and-coming market.

In addition to the above benefit, a 1031 exchange may allow a passive investor to leave a single managed property and invest in various passive investments, spreading the risk across markets and reclaiming time that could have gone into managing and maintaining the property. Investing in a high-value property allows an investor to buy many properties with higher returns based on the value of one.


Invest in properties with higher values.

Deferred 1031 exchanges allow you to trade up to a property or portfolio of properties that will perform better returns or qualities. You will not need to pay taxes on the new investment until you sell (unless you opt to do another 1031 exchange). Using a 1031 exchange, one Roof stock customer doubled the cash flow from a single commercial property to an extensive portfolio of single-family rental properties.

The most adept real estate investors, 1031, exchange their homes in high-tax, appreciated markets. Like California, to get rental properties in lower volatility/more affordable states with a better cash flow. This can generate higher returns in the long run.


What is a 1031 tax-deferred exchange?

Tax-deferred 1031 exchange allows you to defer paying capital gains taxes on appreciated assets by purchasing one or several replacement properties. The 1031 Exchange will enable you to keep your money and equity working for you instead of losing one-third of it to taxes.

As a result of a 1031 Exchange, you can defer capital gain taxes by purchasing one or more replacement properties after selling appreciated assets. Generally, it is rental or investment real estate, but it could also be non-real estate. Tax-deferred exchanges allow you to keep 100 percent of the funds you earn working for you instead of paying taxes on one-third of your funds.

Your sale transaction must meet specific requirements to qualify for a 1031 Deferred Exchange.


Requirements for 1031 Tax Deferred Exchanges

what is a tax-deferred exchange? The sale and purchase transactions must be appropriately structured to be eligible for tax-deferred treatment. The qualified intermediary will prepare all the legal documents necessary to ensure compliance with all laws, regulations, and rulings.

Before closing your purchase and sale transactions, you must assign the Qualified Intermediate to the Purchase and Sales Agreement or Contract and any Escrow Instructions. If your transaction is eligible for 1031 Exchange Treatment, it will be allowed if the Qualified intermediary has yet to be assigned to both transactions.

Structure the sale and purchase transactions correctly to qualify for 1031 exchange tax-deferral treatment. The Qualified Intermediary will complete the necessary legal documents. Often called an Accommodator or Facilitator of 1031 Exchanges.


Requirements for 1031 Tax Deferred Exchanges


Before closing your sale and purchase transactions, you must assign the Qualified Intermediary to the Purchase and Sale Agreement and Escrow Instructions, if any. If either transaction closes without your Qualified Intermediary formally being assigned to both transactions, your transaction is not eligible for 1031 Exchange treatment.


Replacing or reinvesting your investment values

To qualify for a refund, you must purchase replacement properties with a net purchase value equal to or greater than the net sales value of the relinquished property you sold. After the relinquished property sells, you must reinvest all the net cash proceeds. Additionally, you must repay the debt paid off on the sale with an equal amount on the replacement property.

You can always buy replacement properties with more cash. But if you sell them, you must pay capital gain income taxes and may have to recapture depreciation.


Use Qualified Requirements

You must hold your relinquished properties as rental or investment properties or use them in your trade or business to qualify for like-kind replacement properties. To qualify, you must intend to hold the properties for investment purposes and not to sell them. For example, inventory in a real estate business like flipping, developing, or building.


Requirements for similar properties

You don’t have to buy a condo if you sell it, etc. There is a lot of misinformation about what constitutes like-kind replacement property. Any type of real estate held for investment is like-kind to any other kind held for investment. Provided the relinquished and replacement properties meet the qualified use requirement discussed above.

Among the assets you can exchange are:

  • Single-family homes,
  • Multifamily dwellings,
  • Commercial offices,
  • Retail stores,
  • Industrial buildings,
  • Vacant land,
  • Mineral interests,
  • Riparian water rights,
  • And tenant-in-common investments.


Assets with many fractional interests

Repositioning, diversifying, or consolidating your real estate investment portfolio is easy with the 1031 Exchange. By selling a single relinquished property, you can diversify your portfolio and acquire multiple like:

  • Kind replacement properties,
  • Or by selling multiple relinquished properties.

You can consolidate your portfolio by purchasing fewer, more significant, like-kind replacement properties. Alternatively, you can buy or sell fractional (partial) interests in property.


Exchange Structures Under 1031

How does a 1031 tax deferred exchange work? 1031 exchange structures are usually Forward or Delayed, where the relinquished property sells first, and then the like-kind replacement property follows within the prescribed 1031 Exchange deadlines. As part of a reverse 1031 exchange, you acquire the like-kind replacement property first and then sell the relinquished property within the specified 1031 Exchange deadline.

Improvement 1031 Exchanges (Build-To-Suit 1031 Exchanges or Construction 1031 Exchanges) allow you to purchase like-kind replacement property using your 1031 Exchange funds and to build or improve the like-kind replacement property acquired with your excess 1031 Exchange funds.


Exchange Deadlines for 1031 Exchanges

A forward 1031 Exchange must adhere to precise and mandatory deadlines. Forty-five days have given you to identify potential like-kind replacement properties for purchase after the close of the relinquished property transaction, and an additional 135 days must be allowed to complete the exchange by acquiring some or all of these like-kind replacement properties.


Requirements for Identifying 1031 Exchanges

To be eligible for a 1031 Exchange, your Qualified Intermediary must identify your potential like-kind replacement properties within the time limits discussed above. Your identification must comply with one of the following rules:

There are three (3) rules for identifying properties.

It is most commonly used in 1031 Exchange transactions to identify three (3) like-kind replacement properties. This rule permits you to determine at least, however, not more than three (3) possible replacements of similar nature to properties. Even if your intention is just to acquire one property, it is highly advisable to identify three (3) properties. One of the two rules below should apply when diversifying your investment real estate portfolio with more than three potential like-kind replacement properties.


Identification Rule of 200% of fair market value

When identifying more than three (3) like-kind replacement properties under the 200% of fair market value rule. As long as the total fair market value of all of these replacement properties is not greater than 200% of the sale price of the relinquished property. You may identify more than three (3) like-kind replacement properties.


Exceptions to identification rules in 95% of cases

Providing that you have acquired and closed on 95% of the identified fair market value. You can identify as many like-kind replacement properties as you wish.


What Advantage Does the 1031 Tax Deferred Exchange Offer?

The tax-deferred 1031 exchange continues to be used by new and experienced investors. It makes sense, especially with the economic growth and property appreciation we’ve seen in many parts of the country over the last few years. 

In addition to giving investors a massive increase in purchasing power and cash flow, a 1031 tax deferred exchange transaction can offer the benefits of consolidation, diversification, and management relief.

  • Leverage
  • Consolidation/diversification
  • Management relief
  • Increased cash flow/income
  • Power to purchase is increased


The Bottom Line

There are several ways in which investors can defer their taxes with a 1031 exchange:

  1. Invest in wealth
  2. Tax savings, plus
  3. Portfolio expansion

At Attorney Real Estate Group, we have seen this investment vehicle’s power. So, it applies to anyone looking to sell their existing property and trade up for higher cash flow. A 1031 exchange can be a fantastic tool for building wealth over a lifetime if used properly.

The sale proceeds can allow you to purchase more significant properties and defer capital gains tax. If you pass the property to your heirs after you pass away, you can avoid paying the deferred capital gains taxes.

If you plan on selling an investment property or accumulating properties over your lifetime, a 1031 exchange is worth considering. To ensure all the rules apply, working with qualified professionals is essential if you decide a 1031 exchange suits you.

Hedy Ghavidel

HEDY GHAVIDEL Managing Attorney  Roseville Office  1-866-471-6981  info@attorneysre.com Bio...

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