What Is A 1031 Exchange

Posted On Friday, 31 July 2020 02:26

There are numerous benefits enjoyed as a real estate investor, including tax advantages. You can also enjoy deducting other expenses linked to your property, such as property management fees, insurance, and mortgage interest. Moreover, when you’re planning to sell your property, it’s possible to take advantage of depreciation to reduce your tax liability. 

However, upon selling your real estate investment, you’re required to pay a capital gains tax, which may greatly discourage you from cashing in on your property. Fortunately, this needs not to be the case anymore. By hiring an expert, such as the ones from Peregrine Private Capital, you’ll be taken through on how you can safeguard your capital gains using the 1031 tax-deferred exchange. 

Consequently, you’ll be able to sell your property and buy another, thereby deferring the tax payment, such as state capital gains taxes, federal capital gain taxes, recapture of depreciation. As a result, your buying power gets to improve substantially. 

What Is A 1031 Exchange?  

The 1031 exchange, also referred to as Starker or like-kind exchange, is whereby you swap one real estate property for another one. This is made possible by Section 1031 of the IRS code, which allows investors to defer payment on capital gains that are realized after selling their property if they use the profits to purchase another like-kind property. By doing this, you either get to pay no tax or lower your tax liability. 

This is different from the standard guidelines that require you to pay a capital gains tax for selling your real estate investment. As a result of this, some investors often opt against selling their property since doing so proves to be a bad call as they end up paying more than what’s earned from the sale. However, this isn’t always the case if your property’s value has appreciated since you bought it.  

In such situations, you should employ the 1031 strategy to temporarily defer the payment of capital gains tax after selling your real estate property. It’s possible to enjoy this tax-deferred status since you don’t acknowledge any capital gains when switching from one investment to another. Additionally, the best thing about the 1031 exchange is that there’s no set limit restricting the number of times you can rollover the capital gains as long as you buy another like-kind property. Therefore, this means you aren’t required to pay tax until the time you choose to cash out years later. 

Furthermore, the capital gains tax payment will only be made once at the long-term capital gains rate, which at the moment fluctuates between 15% to 20%. Some lower-income taxpayers usually enjoy a 0% capital gains tax rate. 

Steps To Execute A 1031 Exchange

Here are the steps you need to follow when executing a 1031 exchange:

• Sell your real estate investment.
• Give a recognized intermediary the realized capital gain.
• Search for a like-kind property within 45 days.
• Start negotiations with the like-kind property seller.
• Agree on the selling price.
• Instruct your intermediary to send the capital gains to the title company or titleholder.
• Complete the IRS form.

The 1031 exchange is also useful if you’re a business owner and are looking to invest in a different business. This is possible since businesses own personal property, including tangible assets, such as real estate and intangible assets, like goodwill. 

The 1031 exchange also states that the goodwill can’t be exchanged as it is an intangible asset, unlike personal and real property. Likewise, non-depreciable assets aren’t seen as like-kind, so a depreciable asset can’t be swapped for a non-depreciable asset. However, it’s possible to exchange residential property and commercial property or the other way round. 

What Are The 1031 Exchange Eligibility Requirements? 

Only productive property is eligible for the 1031 exchange. This means the real estate should either be used for investment, business, or trade. Therefore, any property used solely or mainly for individual use is exempt from this tax-deferral rule placed under Section 1031, including your second home and your main residence. But, there are times when you can swap your vacation home, for instance, as long as you rarely use the property. 

In contrast, any property you own for investment objectives is eligible for 1031 exchange, including a single-family house, commercial building, an empty lot, or an apartment building. 

Here’s a list created by the IRS showing those eligible for the 1031 exchange: 

• Individuals
• S Corporations
• Trusts
• Partnerships (limited or general) 
• C Corporations 
• Limited liability companies
• Any other taxpaying organization 

Whereas the guidelines stating what can be swapped and who can partake in the 1031 exchange is broad, certain limitations need to be adhered to. One of these is that you’re allowed a maximum of 180 days between the closing date of your replacement property’s purchase and the sale of your first property. You also need to have found the replacement property within 45 days since the sale of your initial real estate. 

Moreover, to make sure all exchange guidelines have been followed, another requirement is that all transactions should be overseen by a certified intermediary, such as the First American Exchange Company. 

Types of Real Estate Exchanges

Once you’ve decided to take advantage of the 1031 exchange to exempt yourself from paying taxes for the accrued capital gains, the next step is choosing the type of exchange. Thus, it’s to learn the differences between them

Here’s a detailed review comparing these four types of exchanges. 

1. Simultaneous Exchange 

With this type of exchange, the closings of the sold property and the acquired property happens on the same day, hence the name simultaneous exchange. The exchange must happen simultaneously or otherwise lead to the disqualification of this exchange and the instant application to pay the total taxes. Therefore, you must ensure there’s no form of delay, for example, the slightest delay when transferring funds to the escrow company. 

Simultaneous exchanges usually happen in three main ways, that is: 

• To ensure the simultaneous transaction, a three-party exchange with the role of an “accommodating party” to act on behalf of the exchanger.
• Complete or swap a two-party trade with the two parties involved “swapping” or exchanging deeds.
• A certified intermediary structuring the whole exchange.

2. Delayed Exchange 

This kind of exchange happens by the exchanger surrendering their original property before buying the replacement real estate. In this instance, the property owned by the exchanger is known as the ‘relinquished property,’ which needs to be transferred first before the exchanger can swap it for the ‘replacement’ property. This is the most common form of real estate exchange that happens in today’s market. 

As an exchanger, it’s your responsibility to market your real estate, find a buyer, and initiate a sale and purchase agreement before the execution of the delayed exchange. After doing this, you should hire a third-party Exchange Intermediary to start selling your initial property, and holding the profit in a trust for a maximum of 180 days as you try and purchase a like-kind property. 

Under the delayed exchange technique, you’re allowed up to 45 days to locate a suitable replacement property. You’re also given 180 days to make sure the sale of your property is complete. 

The prolonged timeframe and various tax benefits are the reason behind the popularity of delayed exchange. 

3. Reverse Exchange

This type of exchange is also referred to as a forward exchange, wherein you’re required first to buy the real estate and exchange it later. In a reverse exchange, you’re first needed to buy a replacement property via an exchange accommodation titleholder. Consequently, you can go ahead and swap this with the real estate you own. 

With reverse exchange, you need to decide the real estate that’s acquired and those that’ll be ‘parked.’ If you don’t relinquish your current property within the set 180-days in which the purchased property is parked, the exchange will be canceled. 

Most of the rules for delayed exchange and reverse exchange are similar, but there are several differences to know, such as: 

• You should identify the property to sell as the ‘relinquished property’ within 45 days. 

• Once the initial 45 days elapse, you’re given 135 days to finalize the sale of the chosen real estate and complete the reverse 1031 exchange by buying the replacement property. 

4. Improvement or Construction Exchange    

This 1031 exchange enables you to use the exchange equity to improve the acquired property. This means you can use your tax-exempt capital gains to improve the replacement real estate that will still be in the custody of a competent intermediary for the remaining 180-day duration. 

If you wish all your capital gains accrued from selling your relinquished real estate and using it for either improvement or construction exchange, there are three requirements you must meet:  

• The property you get must be ‘too a great extent the same property,’ which you’d identified before the 45th day.
• The capital gains should either be spent as the down payment or on finished improvements by the 180th day.
• The value of the replacement property must be greater or equal when it’s handed over to you. Therefore, all the modifications need to be put in place before the qualified intermediary hands over the acquired property. 

Conclusion 

If you’re a property owner, reading through this article has given you great insight on how to take advantage of the 1031 exchange when selling one property for another one. As a result, you get to enjoy increased purchasing power as you don’t have to incur any tax liability for the profit realized upon selling the relinquished asset. 

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