A tax-deferred 1031 Exchange allows investors to defer capital gain taxes in order to facilitate significant portfolio growth and increase return on investment.
IRC Section 1031, a properly structured 1031 exchange allows a real estate investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC Section 1031 (a)(1) states:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade for investment.”
1) You sell your appreciated property and gain a net proceed of $400,000.
2) You expect to incur a tax liability of ~$140,000, leaving you $260,000 net equity to reinvest.3) With a 25% down payment, your purchase price would be $1,040,000 for the next property.
With a 1031 exchange, you could defer the tax liability to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property.
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A 1031 Exchange Qualified Intermediary handles the extra paperwork involved and coordinates with escrow during the closing of each property. Of course, every transaction includes unique considerations, so your legal and tax advisors need to be consulted first.
Below are the general steps involved in a 1031 Exchange
Per the assignment agreement and exchange documents,Intermediary instructs Escrow Officer to directly deed the relinquished property to the buyer. Exchange proceeds are transferred directly to Intermediary via wire transfer.
It is the sole responsibility of the exchanger to meet all identification rules. The exchanger has 45 days to identify the replacement property or properties and 180 days to close the transaction(s).
Specific written identification, signed by the exchanger is forwarded to Intermediary.
Execute contract with the exchanger’s name and/or assigns, and with language recognizing the exchange, with the other party’s consent.
The original documents will be forwarded to the Escrow Officer who will coordinate the signatures.
Per the assignment agreement and exchange documents,Intermediary instructs the Escrow Officer to directly deed the replacement property from the seller. Intermediary wire transfers exchange proceeds to the Escrow Officer.
If all exchange funds are used to acquire the replacement property or properties, and all the exchange requirements are met, the exchange is complete.
Many real estate investors are utilizing the 1031 exchange option once they discover the wide range of investment objectives the strategy meets. Below are 5 objectives worth your consideration:
A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. In other words, the government is offering you an interest-free, no-term loan on taxes due until the property is sold for cash. Often the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange.
Many investors exchange from a property where they have a high equity position, or one that is “free and clear”, into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase the investors’ return on their investment.
Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region, such as exchanging out of one apartment building in Denver, Colorado, for two additional apartments – one in Los Angeles, California, and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type, such as exchanging from several residential units to a small retail strip center.
Some investors accumulate several single family rentals over the years. The ongoing maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and property management. Exchanging into a single apartment complex with is a good example of this strategy.
Sometimes a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property, which they can either hold or sell.
Below are brief descriptions of commonly used 1031 Exchange terminology:
Actual Receipt = Physical possession of proceeds.
Boot = “Non like-kind” property received; “Boot” is taxable to the extent there is a capital gain.
Cash Boot = Any proceeds actually or constructively received by the taxpayer.
Constructive Receipt = Although a taxpayer does not have actual possession of the proceeds, they are legally entitled to the proceeds in some manner such as having the money held by an entity considered their agent or by someone having a fiduciary relationship with them. This creates a taxable event.
Direct Deeding = Transfer of title directly from the taxpayer to buyer and from the seller to the taxpayer after all necessary exchange documents have been executed.
Exchanger = The entity or person who is performing a 1031 tax-deferred exchange.
Exchange Agreement = The written agreement defining the transfer of the relinquished property to the qualified intermediary, the subsequent purchase of the replacement property by the qualified intermediary, and the restrictions on the exchange proceeds during the exchange period.
Exchanged Period = The period of time in which replacement property must be received by the taxpayers ends on the earlier of 180 calendar days after the relinquished property closing, or the due date for the taxpayer’s tax return. (If the 180th day falls after the due date of the taxpayer’s tax return, an extension may be filed to receive the full 180-day exchange period.)
Identification Period = A maximum of 45 calendar days from the relinquished property closing to properly identify potential replacement property or properties.
Like Kind Property = Any property held for productive use in trade or business or held for investment; both the relinquished and replacement properties must be considered like-kind to qualify for tax deferral.
Mortgage Boot = This occurs when the taxpayer does not acquire debt that is equal to or greater than the debt that was paid off on the relinquished property sale; Referred to as debt relief. This creates a taxable event.
Qualified Intermediary = The entity who facilitates the exchange; defined as follows: (1) Not a related party (i.e. agent, attorney, broker, etc.) (2) Receives a fee (3) Receives the relinquished property from the taxpayer and sells to the buyer (4) Purchases the replacement property from the seller and transfers it to the taxpayer; Asset Preservation, Inc. (API) is a qualified intermediary.
Relinquished Property = Property given up by the taxpayer; also referred to as the sale, exchange, down leg or Phase I property.
Replacement Property = Property received by the taxpayer; also referred to as the purchase, target, up leg or Phase II property.