Table Of Contents
- 1 1031 Exchange Info – Complete Insights To Property Investing
- 1.1 What Is A 1031 Exchange?
- 1.2 How 1031 exchanges work
- 1.3 Like-kind properties and exchanges
- 1.4 Types of 1031 exchanges for real estate investors
- 1.5 Getting started with 1031 exchange
- 1.5.1 Avoid Getting The Boot While Replacing Your Property
- 1.5.2 Expenses included in a 1031 exchange investment property
- 1.5.3 Expenses that are not payable via exchange funds include:
- 1.5.4 Exchanging Partners: Drop And Swap 1031 Exchanges
- 1.5.5 Tenancy-in-Common Property Exchanges
- 1.5.6 1031 Exchange Benefit In Estate Planning
- 1.5.7 1031 Exchange Experts
1031 Exchange Info – Complete Insights To Property Investing
1031 exchange is proving to be one of the best ways for savvy real estate investors to expand their portfolios while rapidly growing their net worth. However, the only way to succeed in it is by understanding the complexities of the concept and knowing the common mistakes to avoid. For those wanting to sell their current property to buy a new one, the tax-deferred 1031 exchange is beneficial. Below are the rules, concepts, and definitions related to the exchange.
What Is A 1031 Exchange?
The term comes from the section 1031 IRS code, and it allows real estate investors to swap investment properties for deferment of capital gains taxes. An investor sells one property and uses the proceeds to purchase another within a specific timeline. Investors must meet all the conditions, such as doing like-kind exchanges only and meeting the timeframes stipulated. Failure to do so can lead to tax implications. Only real property that is not a personal residence is allowed, which means the intangible property does not qualify.
How 1031 exchanges work
Also known as like-kind exchanges, 1031 allows real estate investors to swap properties and pay limited or no taxes at the time of transaction. It allows you to switch between different types of real property investments as many times as you wish, so long as you do not receive capital gain, which is also known as cashing out.
The IRS does not have a limit on the number of times you can rollover gains from one investment to the other, which means you can have as many as possible without paying tax and only pay once when you finally cash out. At that time, the amount you pay as tax will depend on the current rates.
1031 exchange rules
The internal revenue service makes the idea of swapping real estate assets seem easy, but it has its challenges. The most common one is finding someone with the type of real property you are interested in or locating someone who wants the property you are willing to trade at fair market value. That is the reason why delays and three-party exchanges are very common. Real property investors are often pushed to work with an intermediary who retains the cash from the first property before using it to buy a new one.
There are three main rules.
The internal revenue service allows real estate investors to find replacement properties within 45 days after the other property has been sold. However, you can start searching for an ideal new property before the sale of the current real estate property.
Investors can also work with a qualified intermediary to ensure the investment meets the 1031 requirements. The intermediary will receive the cash from the sale, after which you inform them about the new replacement property you are interested in getting.
The tax code allows you to have three property options, so long as you end up finalizing payment on one of them within the specified period. All the properties must meet valuation conditions.
Purchases within 180 days
The internal revenue code also states that the purchase of the second property must be finalized within 180 days after the sale of the current property. The delayed exchange rule includes weekends and holidays, which means the duration will be less than six months.
It is important to note that the two timings run simultaneously. For instance, if you designate a property to the intermediary 30 days after you close the sale of the current property, you will have 150 days left to close the purchase.
Higher or equal value on the second property
Properties with existing mortgages can also be used, but the mortgage must have equal or greater value than the one being sold.
In case there is some money remaining after the property exchange, the intermediary will return it to the investor after 180 days. The extra cash is known as BOOT, and it falls under capital gains tax.
To avoid problems during the transactions, factor in all possible debts on the relinquished property. The excess amount after mortgage value deductions is also considered as boot and must be taxed. Even if you do not get the extra funds back and it is used to reduce your liability, it will still be considered income.
Like-kind properties and exchanges
To use like-kind properties means acquiring properties of the same nature as the ones sold. However, it does not mean they must be the same. For instance, a beach house can be exchanged for an office building, the same way an apartment building can be exchanged for a shopping center. Industrial property can also be swapped for raw land, but real estate property cannot be used for other assets like artwork or other collectibles. The properties are not to be sold or used as primary residences.
If you buy a personal property intending to sell it for a profit, it may not qualify. The same applies to a property exchange that is done too quickly after acquisition or dealing with too many properties within one year. You could be labelled a dealer, like investors in the stock trade, in which case you will have to prove that the property you bought was strictly for investment purposes and not for fixing and flipping.
Some of the factors likely to be considered during the property trade include a motive for the acquisition of the new property, the duration that property is held, and the business dealings of the investor.
Finding replacement properties
The potential replacement property must be identified within 45 days after closing the deal on the sale of the current property. The three-property rule states that investors can identify, and if possible, acquire all three properties. Given the short period, knowing where to apply market research is crucial.
You can work with a real estate broker that has established a relationship with most investors dealing with business properties. You could also check out real estate websites that display personalized ads for real property investors. Whatever method you use, keep in mind that involving an escrow officer will increase your chances of completing the 1031 exchanges successfully.
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 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. 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.
The tax deferral is the benefit that many property investors eye when opting for 1031 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 1031 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 transactions due to their complexity.
Understanding Depreciation And Its Significances To A 1031 Exchange?
To understand the benefits of opting for a 1031, 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, the replacement property must be of 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 is finalized within 180 days as outlined above.
Three rules can be applicable when defining identification. You will have to meet any of the following:
Types of 1031 exchanges for real estate investors
There are three main types of 1031 exchanges used by real estate investors. Each of them has different conditions and requirements that must be followed.
A delayed exchange can happen with a single sold or relinquished property or with a simultaneous selling and replacement. These types of 1031 exchanges mostly fall under the 180-day rule, which means the transaction must be completed within that timeline.
After the real property sale is completed successfully, the proceeds will be taken to an intermediary who is qualified, after which the investor identifies suitable replacement properties before 45 days elapse. The intermediary will then transfer the real estate funds to the seller of the other property and complete the purchase within 180 days from the day the first sale was done.
Alternatively, the investor can identify the replacement while the sale of the first property is underway and still complete the entire process with the help of the intermediary within the specified number of days.
Build to suit exchanges
The internal revenue code also allows investors to use renovated or newly-built replacements in a 1031 exchange. This option requires extensive estate planning because the deal must still be completed within 180 days. You can buy vacant land for the construction of the real property and ensure it is finished at the same time the transaction is completed. However, you cannot start the renovation or building process while the original property is still being sold. Any work done on the site after time elapses will result in the property being labelled a personal property, which will disqualify it from the 1031 exchange.
Reverse exchange is applied when there is an acquisition of the replacement property prior to the sale of the other property. However, the property will remain in the possession of an exchange accommodation officer, which can be an escrow officer or other intermediaries who are qualified. There must be a written agreement, with the entire process being completed within 180 days.
Getting started with 1031 exchange
Starting a 1031 exchange is simple, especially when you have already chosen the real property you want to sell. You can then contact an exchange facilitator with information like the property address, phone numbers, and personal data of the people involved, and file numbers for the properties in question. Different exchange coordinators ask for varying details, depending on their company policies and the properties involved. Make sure you find a qualified intermediary before selling the property.
If you get any offers on replacement properties, you will need an addendum to prove that you will use the property as a 1031 exchange. Send the contract to your intermediary and wait for the sale of the first property to be completed. Look for ideal replacements and send the details for each to the intermediary. Make sure you do not exceed 45 days.
Choose one or up to three properties to purchase and have a contract drafted. Send it to a qualified intermediary, and they will guide you through an assignment contract.
Close the deal on the replacement property prior to 180 days, then file form 8824 to inform the internal revenue service that you have completed a 1031 exchange. File the tax return for the year the original property was sold. A tax professional can help you finalize this step.
Service providers included in the 1031 exchange process include:
Real estate agents: These people can help you identify potential properties at fair market value, especially when you work with those who have experience with 1031 exchanges. They will also know potential property owners with a legitimate interest in selling.
Tax attorney: Whether you choose to buy one investment property or three, a tax advisor can help you capitalize on the tax loopholes to ensure you defer taxes where possible. They can also help with the filing of tax returns when the exchange is completed.
Facilitator: The exchange coordinator can help you process personal data and ensure the transaction goes smoothly.
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:
Expenses included in a 1031 exchange investment property
- – 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
The costs for closing a 1031 exchange are usually the same as those in the real estate sector. However, the specific amount will vary depending on the type of transaction and the circumstances surrounding it. In cases of a swap, the cost can be as little as $500, while the least amount of expenses in delayed exchange is $750. A reverse exchange, on the other hand, will cost up to $3,500. Your legal and lender fees could also increase the total amount. The expenses will also increase with the changes to improve the property.
The exchange accommodator can help you understand the costs involved and how they can assist in case a problem arises before the transaction is completed.
According to the IRS code, some closing fees can be cleared with the exchange funds and others cannot. The exchange expenses are known as reduction of boot, whereas the non-exchange ones are taxable boot. Some of the services under Exchange Funds are legal and escrow fees, transfer taxes, sales commission, property taxes, and title insurance fees, among others. Security deposits, application fees, mortgage insurance, and homeowners’ fees are under the Non-Exchange Expenses.
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 are governed by universal basics.
An LLC member or partner wishing to make a 1031 exchange and other members who 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 receive 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.
In case the real property interest is owned in an LLC, and only one partner wants to engage in a 1031 exchange, they can transfer their interest to the company for a deed of a percentage of the business property. The partner becomes a separate taxpayer, which means that upon the sale of the property, the partner’s shares will be transferred to an intermediary, while the rest of the partners get their proceeds directly.
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!