Expounding On The Basics Of 1031 Exchange For Real Estate Investors
You should familiarize yourself with 1031 tax-deferred exchange if you own an investment property or thinking of selling and buying such properties. The 1031 tax-deferred exchange allows property owners to sell and buy similar property while deferring (postponing) capital gains tax. In this article, we will highlight the essential elements of the 1031 exchange; the concepts, definitions, and rules you must know regarding investment property transactions.
What Is A 1031 Exchange?
In this age of specialized terminologies, it is wise to start with the basics when thinking of investing. If you are interested in investment properties, then you should learn as much as you can about a 1031 exchange. Its name is derived from Section 1031 of the U.S. Internal Revenue Code. The 1031 exchange grants leeway, a pass of sorts, exempting you from paying capital gain taxes after selling your investment property; thus, you can reinvest the sale’s proceeds within specific time limits in a similar property of equal or greater value.
The Role Qualified Intermediaries Play
Section 1031 stipulates that all proceeds of a property sale are taxable; thus, they must be transferred to a qualified intermediary (who can be a company or person) instead of the property seller. Moreover, the qualified intermediary will transfer the proceeds to the replacement property seller or the property in question.
A qualified intermediary is an entity (person or company) facilitating the 1031 exchange by acting as a funds-holder in the transaction. They hold the money until the proceeds are ready to be transferred to the replacement property seller. However, the qualified intermediary must have no existing relationship with the parties transacting the investment properties, formal or otherwise.
When Should You Consider A 1031 Exchange?
Investors will have varied reasons for considering leveraging a 1031 exchange. Some of the common reasons for such an option are:
- Searching for a better property that promises better returns or the need for asset diversification.
- The investment property owner might be looking for managed real estate instead of undergoing the hustle of managing the property.
- The need to consolidate some properties into a single investment portfolio for better estate planning. For instance, it can be to split the property into several assets.
- Resetting the depreciation clock (which we shall expound further)
The tax deferral is the benefit that many property investors eye when opting for a 1031 exchange instead of selling a property and buying another of equal or greater value. With the 1031 exchanger, the property seller and defer capital gains tax therein having more capital for investing in a like-kind replacement property.
You must note that a 1031 exchange might entail a comparatively longer holding time and a high minimum investment. Therefore, such real estate transactions are perfect for investors with higher net worth. Furthermore, duly qualified professionals are the ones mandated to handle 1031 exchange transactions due to their complexity.
Understanding Depreciation And Its Significances To A 1031 Exchange?
To grasp the entirety of the benefits of opting for a 1031 exchange, you must understand what deprecation is and its impact on investment property transactions.
Depreciation is an annual written off amount (percentage of an investment property’s cost) influenced by wear and tear. During a property sale, capital gains taxes are calculated based on its adjusted net cost reflecting its original purchase (acquisition) price and capital improvements, less depreciation.
If the property’s market value or sale exceeds its depreciated value, you may need to consider depreciation recapture. It means your taxable income for the property sale will be inclusive of the deprecation amount.
With the depreciation recapture increasing in size with time, investors should always be ready to consider utilizing a 1031 exchange to avoid the significant increase in taxable incomes associated with the depreciation recapture in the future. Therefore, depreciation recapture is a crucial element worth considering when determining a 1031 exchange transaction value.
Choosing A Replacement Property: Timing & Rules
A property of like value is defined not on its quality or grade but its nature or characteristics. Subsequently, it means you can pick for a plethora of exchangeable real estate. For instance, you can exchange a vacant plot for a commercial building or residential land for industrial property. However, you cannot exchange real estate for other assets like machinery because they do not qualify as like-kind. Moreover, the property should be held for investment, not personal use, or resale. It is a factor that evokes two-year minimum ownership.
To enjoy the benefits of a 1031 exchange, the replacement property must be of a greater or equal value. Therefore, identify real estate as a replacement for the asset you are selling within 45 days after the sale and ensure the exchange takes place and is finalized within 180 days.
Three rules can be applicable when defining identification. You will have to meet any of the following:
1). A three-property rule that lets you identify three potential properties worth buying irrespective of their value.
2). A 200% rule grants you the room to search for unlimited replacement properties as long as they have a cumulative value below 200% of the sold property’s value.
3). A 95% rule in which you can identify different properties of interest as long as what you purchase is valued at least 95% of their total.
The Different Like-Kind Exchanges
Investors can make 1031 exchanges in various ways varying in timing and other details, and each has a set of unique requirements and procedures to follow.
A 1031 exchange that must be concluded within 180 days is referred to as a delayed exchange because exchanges had to be executed simultaneously at one point.
With a build-to-suit exchange, the replacement property in the 1031 exchange can be newly constructed or renovated. Nevertheless, it is a transaction subject to the 180-day completion period. That means all construction improvements must be finished by the time the exchange is concluded. Any renovations made afterward will be regarded as personal property and disqualified from being part of the exchange.
If the replacement property is acquired before the property’s sale to be exchanged, the transactions will be considered a reverse exchange. Therefore, the said property will be transferred to an exchange accommodation titleholder (such as a qualified intermediary) and a qualified exchange accommodation agreement drawn up and signed. The replacement property must be identified within 45 days of the transfer of the real estate and the transaction carried out within the stipulated 180-day period.
Avoid Getting The Boot While Replacing Your Property
Like-kind properties in a 1031 exchange should be of a similar market value to the property to be sold. A value difference between properties involved in the transaction is known as “boot.”
When a replacement property’s value is lesser than that of the property sold, the difference (also known as the cash boot) is taxable. If a non-like-kind property or personal property is used in completing the exchange, it also qualifies as “boot” but is not barred for a 1031 exchange.
An existing mortgage on either property involved in the exchange is permissible. If the replacement property’s mortgage is less than that of the property on sale, the difference will be considered a cash boot. It is a fact worth considering when determining the 1031 exchange parameters.
Keep in mind that expenses and fees influence the transaction’s value and the potential boot. Some expenses are payable with exchange funds; they include:
- – Broker’s commission
- – Escrow fees
- – Filing fees
- – Finder fees
- – Title insurance premiums
- – Qualified intermediary fees
- – Related tax adviser fees
- – Related attorney’s fees
Expenses that are not payable via exchange funds include:
- – Repair or maintenance costs
- – Property taxes
- – Insurance premiums
- – Financing fees
Exchanging Partners: Drop And Swap 1031 Exchanges
An LLC is only mandated to exchange property as an entity unless it does a drop and swap in the vent some of its partners wish to have a vested stake in the exchange, and others do not.
Partnership interests cannot be used in a 1031 exchange; that is why LLCs’ partners do not own real estate gut interest in the said property the LLC owns. As such, the LLC is the property’s taxpayer. 1031 exchanges are done by a taxpayer on either side of the transaction. Special steps are necessary when LLC partners or members are not in agreement regarding the property’s sale or disposition. It is a matter that complicates things because every property owner’s situation is unique, although all governed by universal basics.
An LLC member or partner wishing to make a 1031 exchange and other members are not interested in the same transaction can transfer partnership interests to the company in exchange for a deed equivalent to a percentage of the property’s value. As a result, the partner becomes a “Tenant in Common” with the LLC and subsequently a separate taxpayer. Suppose the LLC property is sold, the said partner’s percentage of the sale proceeds goes to a qualified intermediary, and other partners receiver their proceeds directly.
Suppose a significant number of the LLC partners are interested in a 1031 exchange. In that case, those opposed or disinterested in the transaction can get a certain percentage of the property and pay taxes on the transaction’s proceeds while what the others get goes to a qualified intermediary. This is what’s called a “Drop and Swap” and is the typical procedure for such situations.
A 1031 exchange done on properties held for investment considers “Holding for Investment,” which is the time an asset is held. In such an instance, a drop (of the partner) swap will be worth initiating at least 12 months before the asset swap. Otherwise, the IRS will regard the participating partner(s) to have failed to meet that criterion. And if that is impossible, the exchange can happen, then the partner(s) that wish to exist can do so after a reasonable period. This is what’s known as “Swap and Drop.”
Tenancy-in-Common Property Exchanges
A tenancy-in-common exchange is another variation of a 1031 exchange transaction. But unlike a drop-and-swap, it is a joint venture (partnership) – that might not be permissible in a 1031 exchange – but is a relationship allowing you a direct fractional ownership interest in a massive real estate having 1 – 34 entities. It allows relatively small people to invest in a real estate transaction and several applications in 1031 exchanges.
In retrospect, tenancy-in-common allows an investor to co-own real estate with other people or entities but holds the same rights as a single owner. Such owners do not need permission for other owners to sell their share of the property. However, they often are expected to meet certain financial demands for accreditation.
Tenancy-in-common can be used in consolidating or dividing financial holding, gaining a share in a larger asset, or diversifying holdings. It allows the investor to specify the project’s investment volume, which is essential in a 1031 exchange where a property’s value must match another.
1031 Exchange Benefit In Estate Planning
One of the notable benefits of a 1031 exchange is the tax deferment is long-term. That means those designated to inherit the property you acquire through a 1031 exchange will own real estate whose value is “stepped up” to a fair market. It subsequently does away with the tax deferment debt.
It means, if you die while still owning real estate purchased through a 1031 exchange, its heirs inherit it at a stepped-up market value with all the deferred taxes erased. Nevertheless, it is wise to consult an estate planner to take full advantage of the opportunity. Moreover, property owners can use tenancy-in-common in structuring their assets to their preferences for distribution after their demise.
1031 Exchange Experts
The tax deference that a 1031 exchange provides is an opportunity that real estate investors should maximize, even though it can be complicated at some points. However, those complexities are the reason for its incredible flexibility. Nevertheless, the 1031 exchange is not for investors that act alone. It has unique processes that necessitate the need for professional guidance at nearly every step.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice because it’s third-party information, coming from authors whom TransFS believes are knowledgeable and reliable resources but we can’t make any guarantees about the accuracy of their content so use this information at your own risk!