One of the least well known benefits of investing in real estate may be the 1031 exchange. This offers a number of tax advantages, but is often misunderstood. It is essential to have the capacity to protect taxes, which leads one to inquire: What is a 1031 exchange? In other words, the term “1031 exchange” is widely associated with the extraordinary advantages that come with investing in real estate. When done properly, a 1031 exchange can benefit investors with a huge reduction in their taxes, making it possible for their portfolios to expand.
Sadly, a great deal of investors do not recognize the advantages of the 1031 exchange, as well as how to properly deploy this tactic. If you are considering putting your investment real estate up for sale or expanding your real estate investing venture, make sure you are familiar with the idea of a 1031 exchange. This tactic could be the key to propelling your job to the higher level.
One of the best companies that work on 1031 exchanges is Api Exchange. They’ve been in the business for decades and we at 40PlusFinance.com know some of their executives and they are extremely knowledgeable and experienced.
What Is A 1031 Exchange – The Basics Explained
A 1031 exchange is when you trade an investment property for another one within a specified timeframe, thereby exchanging the two pieces of real estate. As outlined by the Internal Revenue Service (IRS), Section 1031 of the IRS code enables taxpayers to postpone capital gains taxes. Under a 1031 exchange, business or investment properties are usually involved, although very rarely there are cases where vacation homes and primary residences qualify as well. There is no set restriction on how many times or how often an investor can employ a 1031 exchange. An example of an investment strategy would be to employ a 1031 exchange when purchasing and selling a hands-off income property. The investor may create a portfolio with tax deferrals in place.
It is important to remember that a 1031 exchange will postpone taxes being paid only if specific requirements are fulfilled. This includes the use of all sale proceeds for the purchase of a ‘comparable’ asset. ” The Internal Revenue Service states that when business or investment property is sold and generates a profit, the associated taxation generally has to be paid right away. Section 1031 of the Internal Revenue Code (IRC) allows you to defer paying tax on gains you have made if you reinvest the funds into a similar property as part of a Qualified Like-Kind Exchange. This type of exchange offers investors the opportunity to offset the capital gains tax, as long as the new property meets the guidelines determined by the IRS.
Who Can Take Advantage Of A 1031 Exchange?
In order to take part in a 1031 exchange, you have to be somebody who owns assets for investment or business purposes. The Internal Revenue Service (IRS) elucidates that individuals, C corporations, S corporations, partnerships (general and limited), limited liability companies, trusts, and any other taxpayer are allowed to trade enterprise or securities for enterprise or securities via Section 1031.
Apart from possessing an investment or business property, there are additional factors that need to be taken into account. At the beginning, not every investment property meets the criteria to be a viable candidate for a 1031 exchange. In order to meet the criteria, the asset that was secured must have been for the purpose of creating a ‘passive income’, like a standard rental property. Rehabs, on the other hand, do not qualify. Rehab properties are not intended to generate passive income but instead, to be used with the expectation of achieving capital gain. In addition, the same individual must own all of the properties in an exchange that is structured as a 1031. This implies that an individual investor is unable to sell a real estate investment held under their own name and buy a similar one under their limited liability company (LLC).
I want to make it perfectly clear; the real estate must have been employed as an investment in order to gain non-active revenues. Typically, property which is used for personal purposes, such as a primary residence, will not fulfill the criteria of a 1031 exchange. In order to ascertain which transactions qualify for a 1031 exchange, one should examine the Internal Revenue Code stipulations as outlined by the IRS. This article offers a brief overview of what to anticipate but does not provide tax advice.
How Does A 1031 Exchange Work?
Those who have taken full advantage of a 1031 exchange have noticeably gained from postponing the payment of taxes until a later date. Delaying capital gains payments can be a highly effective strategy for tax relief, so how does a 1031 exchange work? The answer can be broken down into five simple steps:
- Choose A Subject Property To Sell: Identify the property which is to be sold for a capital gain.
- Choose A Subject Property To Buy: Identify a subject property to buy with the proceeds from the sale of the first home.
- Make Sure Each Property Is “Like-Kind”: The properties being bought and sold must be like-kind. For two properties to be of like-kind, they must be similar in nature and character. The quality or grade of the subject properties isn’t relevant; only that they are objectively similar types of physical real estate.
- Execute The Transaction With A Qualified Intermediary: In the event each subject property qualifies as like-kind, investors must execute the transaction with a qualified intermediary. Otherwise known as exchange facilitators, the proper intermediaries will carry out the transaction with their own escrow account to keep everything in order.
- Inform The IRS Of The Transaction: When it comes time to file taxes, fill out IRS Form 8824 to inform the IRS of the transaction. When filling out the form, describe the subject properties, identify the dates, explain who was involved, and keep records of the flow of money.
Special Rules for Depreciable Property
Special rules apply when a depreciable property is exchanged. The sale of an asset can generate a form of earnings referred to as depreciation recapture, which is taxed as general income.
Generally, you can prevent the recapture taxation if you exchange one structure for another. If you move from improved property, on which you have already taken a depreciation deduction, to property that lacks a building, then the depreciation you have already claimed will have to be reported as regular income.
This is why it is advisable to hire professional assistance when completing a 1031 exchange.
Changes to 1031 Rules
Prior to the TCJA, certain swaps of personal items like franchise permits, planes, and appliances were allowed to make use of the 1031 Exchange. Just belongings that are defined in Section 1031 of the law are now the only things which can be thought of as real estate.
It should be kept in mind that the Tax Cuts and Jobs Act could cover the modifications in the taxation regulations through permitting you to fully subtract some tangible personal property.
A transition provision in the Trump-era Tax Cut and Jobs Act allowed for trades of qualified personal property during 2018 if either the original asset was sold or the replacement asset was acquired before the end of the calendar year 2017.
The regulation in question only applies to a particular taxpayer and does not authorize a 1031 exchange in the opposite direction, i.e., the purchase of the new property before the sale of the old one.
1031 Exchange Timelines and Rules
Traditionally, two individuals exchange items by exchanging one thing for another. It is unlikely that you will discover someone who precisely wants the same property as you have, and desires the exact property that you are offering. The delay, three-party, or Starker exchange is largely utilized due to the fact that the first tax case to allow for its usage happened. This exchange takes its name from the court case.
In a delayed swap, you would need to enlist the assistance of a knowledgeable mediator (interim individual), who keeps the money after you offer your property and uses it to purchase the substitution property for your benefit. This three-party exchange is treated as a swap.
You need to follow two regulations of timing when engaging in a delayed trade.
45-Day Rule
Identifying an alternative property to be exchanged. When the sale of the property is completed, the intermediary will be paid the money. It is not permissible to get any funds from this 1031 exchange method, or else the whole endeavor will fail. Within a period of 45 days after you have sold your real estate, you must write to the go-between and specify which property you desire to purchase.
The Internal Revenue Service declares you can choose up to three properties as long as at least one of them is purchased in the end. Alternatively, you can assign more than three if they meet certain standards for worth.
180-Day Rule
The closing of a delayed exchange is subject to a second timing rule. You have to finalize the purchase of the new property within a period of 180 days after selling the existing one.
Reverse Exchange
It is permissible to acquire the newly purchased property prior to the sale of the original, granting you authorization to participate in a 1031 exchange. In this instance, the 45- and 180-day durations still apply.
You will be eligible to qualify if you arrange for the transfer of ownership of the new property to an exchange accommodation holder, designate another property to replace it within a period of 45 days, and complete the exchange deal within 180 days of buying the replacement property.
Like-Kind Exchange
A 1031 like-kind exchange is when an investor offloads a rental asset and utilizes the earnings to purchase a corresponding asset, raising the inquiry: What precisely is a similar kind property? To what extent must properties be alike (or different) in order to qualify for a trade?
The IRS states that like-kind properties must be similar and equivalent. Qualifying properties for 1031 like-kind exchange must be comparable in nature or kind, even if there is a disparity in standard or excellence.
According to Section 1031 regulations, almost all assets can be swapped for ones of a similar nature. Of course, there are exceptions. In the United States, real estate cannot be considered to be the same as properties located outside of the country. To find out what’s classed as like-kind and what isn’t, it is advised to seek advice from a tax specialist.
Built-To-Suit Exchange
Otherwise known as a building swap, a designed-for-purchase exchange gives buyers the option to utilize the postponed profits from the given up resource to support restorations on the substitute resource. It must be taken into consideration, however, that all renovations to the new house should be completed within the 180-day period so that deferred tax money can be claimed in time for the necessary tax filing.
1031 Exchange Tax Implications: Cash and Debt
You may have funds remaining after the middleman obtains the substitute asset. The intermediary will give you the money at the completion of the 180 day period. The money you have earned, referred to as boot, will usually be seen as part of the profit from the sale of your property and be subject to as capital gains tax.
People can land in hot water if they overlook the potential of taking out loans when dealing with monetary transactions. You have to bear in mind any loan or other obligation tied to the property you are surrendering, as well as the debt surrounding the property you are obtaining. Not receiving cash back but having your liability decrease is seen as the same as cash, and is therefore deemed as income.
If you had a loan of one million dollars on the aged property, you would be offered a loan of nine hundred thousand dollars on the fresh property which you receive in exchange. You would then be liable for taxes on the $100,000 that is regarded as the boot.
1031s for Estate Planning
An undesirable aspect of 1031 trades is that the postponed taxation will at last come due and you will be facing an enormous financial liability. However, there is a way around this.
If someone passes away without selling the asset they bought in a 1031 exchange, then their heirs will not have to take care of any taxes that they didn’t already pay on it. They will acquire the asset with its increased price in line with the current market value.
The regulations set forth in a 1031 exchange make it beneficial for estate planning.
How to Report 1031 Exchanges to the IRS
It is mandatory for you to inform the Internal Revenue Service about the 1031 exchange by accumulating and giving in Form 8824 with the yearly tax return when the exchange took place.
You must fill out the form which requires you to supply details of the possessions exchanged, the moments when they were identified and shifted, any association between you and the other individuals who participated in the exchange and the worth of the alternatively equal properties. You must tell the authorities the status of the property that was exchanged, the re-evaluated cost, and any debts you took on or released.
It is vital to fill out the document accurately and with no mistakes. If the Internal Revenue Service has reason to believe you did not adhere to the regulations, then you might end up facing a sizable tax debt plus fines and penalties.
What Is an Example of a 1031 Exchange?
Kim is the owner of an apartment complex that is currently valued at $2 million, an amount which has been doubled since she bought it seven years ago. The woman is satisfied until the realtor informs her about a more spacious condominium in an area that commands higher prices available for $2.5 million.
Kim could execute a 1031 exchange to sell her apartment building and utilize the funds to pay for the new and larger property, avoiding any immediate tax obligations. She has the potential to invest more in the new property by postponing capital gains and depreciation recapture taxes.
The Bottom Line
Savvy real estate investors can utilize a 1031 exchange as an approach for postponing tax payments, leading to increased wealth. Despite having a great familiarity with the process, investors need to be cognizant of the numerous intricate elements involved and seek professional assistance to ensure successful investments.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor owning properties in multiple states.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here.
