 1031 Exchange Properties | |
What is a 1031 exchange?
An IRC 1031 Tax Deferred exchange has been around since 1921. It is a powerful wealth building vehicle that allows investment property owners to defer capital gains taxes on the sale of investment property by reinvesting the proceeds into another investment property. Under section 1031 of the Internal Revenue Code is defined as:“No gain or loss shall be recognized on the sale of property held for productive use in a trade or business or for investment purposes, if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or investment”.
1031 Exchange Timeframes/Deadlines
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The exchanger has 45 calendar days from the close of escrow on the relinquished property to identify their replacement property(ies)
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The exchanger has a total of 180 calendar days from the close of escrow on the relinquished property, or their tax filing date, whichever comes first, to complete the purchase of the replacement property(ies). If the tax filing date comes earlier than the 180th day, the exchanger may want to file an extension to allow them the full exchange period.
Identification Rules
Three-Property Rule- This is the most common rule utilized by taxpayers. This allows investors to identify any three properties regardless of value, but the investor must complete the exchange on at least one of the three properties identified.
The 200% Rule- This allows the exchanger to identify any number of properties, so long as the aggregate fair market value of all the properties identified does not exceed 200%(2X)of the value of the relinquished property.
95% Exception-If the taxpayer (exchanger) violates both the three property rule and 200% rule, which means the exchanger identifies more than three properties and the value of all the properties identified exceed 200%, then the taxpayer must acquire 95% of all the properties identified. Realistically, the taxpayer/exchanger would have to acquire all the property(ies) they identified, which is highly unlikely.
1031 Exchange Equity and Value Requirements
In order for the exchanger to defer 100% of their capital gain taxes there are three rules that have to be met by the investor:
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Exchanger (Taxpayer) must reinvest all their net equity proceeds into the replacement property
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Purchase replacement property(ies) that is equal or greater than the net sales price of the relinquished property.
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Obtain equal or greater debt on the replacement property. Additional cash from the exchanger can offset the debt, however, increasing the debt cannot offset a reduction in cash equity.
What is “Like Kind” Property?
Under Section IRC 1031 Tax Code, in order for property to qualify as like kind property, the investors relinquished property and replacement property both must be held for productive use in trade or business, or investment purposes.
Rental Home for Multi Family Apartments
Non Income Producing Vacant Land for Income Producing Office Building
Farm Land for Retail Shopping Center
Mixed Use Property (Investment and Personal) for Industrial Property
Four plex for fee simple interest in 30 year lease
Benefits of Exchanging
One of the most powerful advantages of utilizing the 1031 exchange is that it allows the investor to increase their overall net worth by the ability to continuously compound tax deferred dollars and leverage into higher valued property. It is a powerful real estate investment-planning tool that allows investors to achieve various investment objectives. They include the following:
Reduce Management Responsibilities-Exchange from management intensive property ( i.e. apartments) for a more passive type property(i.e. Triple Net Property or tenant in common investment)
Improve Cash Flow/Appreciation Potential –Exchange from non-income property (land) for income property (retail)
Diversify or Consolidate-Exchange one larger property and diversify for multiple smaller properties in different geographic locations, or exchange multiple properties and consolidate into one larger property.
Retirement/Estate Planning- With some advanced planning you can exchange your investment property for a home or condo in an area that you eventually plan to retire to-it is recommended that the investor consult a tax or legal professional when planning such exchange. Upon death of the exchanger, the tax deferred gain that has compounded over the years will be wiped out, and the heirs will get a stepped up basis on the property inherited. (For example, to simplify estate planning, an older person could exchange an apartment building for two smaller properties to eventually leave for their two kids to inherit upon death)
Relocation - Relocate your investment property closer to where you reside.
Dissolve Joint ownership-Exchange out of property owned jointly for a sole ownership property
Increase Depreciation Deductions- By exchanging up it allows the investor to increase the adjusted basis and tax deductions on depreciating asset. The amount of depreciation is calculated by the purchase price minus the deferred gain.
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