What Is The 1031 Exchange?

By  //  December 4, 2020

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You may not know it, but as an investor, you could be using real estate to your advantage. This could include contract flipping, owning vacation rentals, hard-money lending or more. No other industry has earned anyone more than the business of property, land, air rights and underground rights.

It’s for this reason that real estate investors are exploiting the 1031 Exchange IRS tax code as well.

Originally known as IRC Section 1031 and created in 1921, it still serves two of its three then-purposes to this day. One is to prevent the unlawful amount of taxation on active property investments, and the second to encourage reinvestment. Today, it is primarily for deferring taxes and making a switch from one “like-kind” property to another.

How The 1031 Exchange Works 

You can use the 1031 Exchange as many times as you like, as long as you follow the rules and processes to the letter. You can keep gaining profit over and over until you decide to sell the property you bought.

During the time of the swap, a qualified Peregrine Private Capital intermediary facilitates the 1031 Exchange and holds the funds from the sale until they need to be transferred to the owner of a replacement property.

The process is the same if you are the seller of the rental home. Remember to never touch the funds from the sale other than to buy a property, or else the IRS will deduct the tax from it.

Avoiding Heavy Taxation 

Real estate investors can avoid two types of taxes this way: capital gains and depreciation recapture.

If you sell a property for more than what you paid for it, capital gains tax is deducted from that sale. As an example, you closed a deal on a rental property for $250,000.

Then you decided to sell it for $275,000, leaving you with a $25,000 profit. The difference in tax rates will depend on how long you owned the property. If you had it for at least a year, the deductibles might be agreeable. However, if you only had it for less than a year, regular income tax will be taken from the proceeds.

On the side of depreciation recapture, it works like this:  

Investment properties are naturally susceptible to wear and tear, thus the value becomes lower and a fixed amount is deducted annually, for a period.

The deductions you claimed over the years become taxable once you decide to sell the property. Let’s say you bought a condo for $180,000 a decade ago and you sold it for $220,000.

The amount of regular income tax will depend on the total amount of depreciation deductions. If you claimed $60,000 in total deductions, 24% will be taken off from the sale proceeds.

Now add the capital gains tax to the depreciation capture tax that you have to pay once you sell your investment property – you’re talking tens of thousands. By now, you’ll understand why investors would pick 1031 Exchange over other options.

The IRS Rules And Requirements On Property Swapping 

So why do investors go crazy over it? Deferred taxes mean that you get to keep the money you owe from selling a rental property you own (where the 1031 Exchange is limited to) in exchange for a new one.

If you don’t receive the actual proceeds, there is no income to tax. The proceeds from the sale are used to acquire additional property instead. The IRS will only allow you to utilize this tax code through the following:

Property Requirements 

The property you must acquire (replacement property) should have equal or greater value to the one you want to sell (relinquished property). That means if you sell a rental home at $500,000, you need to buy a similar singular or multiple properties amounting to $500,000 as well. Just the same, if your property has a mortgage then you will have to take out a loan to finance the replacement property.

Same-Type Properties 

The IRS also puts the restriction heavily on the “like-kind” part of the exchange. Some may think that you can’t sell off vacant land with a building for a warehouse. In truth, it can be any property as long as they qualify for non-taxation under the 1031 Exchange.

Keep in mind that this tax code only applies to investment properties; you can’t swap a family home for another. It also applies regardless of the quality of both relinquished and replacement properties. You can choose to improve a replacement property later on during a specific type of exchange that allows you to do so.

Here are examples of “like-kind” property exchanges:

1. Swap a duplex for an apartment

2. Retail property for a hotel

3. Multifamily property against an industrial building

4. A medical center for a vacant land

That 1031 Exchange, also known as the Starker Exchange, also welcomes multiple properties for exchange, as long as they qualify.

One example is that if you’re looking for two vacation rentals, you must relinquish one or two that amount to the same price as the replacement properties. A financial advisor or an experienced intermediary may be necessary to give solid advice in this department.

Time Restrictions 

The escrow company will only allow you 45 days to name the replacement property from the time when you sold your rental property.

Then within another 180 days, you have to close the deal on the replacement property from the time when the relinquished property deal was closed. It’s imperative that you act fast once you’ve applied for the 1031 Exchange.

Location 

Under the IRC 1031 tax code, only replacement properties within the United States are subject to the 1031 Exchange.

Four Types Of Exchanges 

There is no one fixed way of exchanging real estate properties. There are four from which you can pick, depending on what will benefit you the most.

Simultaneous Exchange

This type of exchange occurs when the relinquished and replacement property close on the same day. It is strictly imposed that the exchange should occur at the same time, or the owners forfeit the chance to claim the 1031 Exchange.

No delay qualifies as an excuse and even one will disqualify both parties. Swapping of property deeds can happen two-way between the buyer and the seller, or when an intermediary acts as the facilitator.

Reverse Exchange 

Am exchange accommodation titleholder is involved and holds the title of the replacement or relinquished property until it can be transferred to a buyer.

You get to buy a replacement property first, and you can choose to sell yours a bit later on if you wish. However, the exchange must happen within the given 180 days, or you forfeit the transaction.

Reverse exchanges come with challenges such as the refusal of banks to approve loans for it. You may have to liquidate other assets if you don’t have enough cash on hand.

You have 45 days to name the property as a relinquished property – one that you will sell, and another 135 to close the sale and end the entire exchange. Within this period, you must be the new owner of the replacement property.

Delayed Exchange 

In this exchange, relinquishing your property happens first, and the acquisition of the replacement property happens later. You become your own real estate agent, and find a buyer as well as close the deal.

Only then can you hire an intermediary, who must be present at the sale and protects the funds in a binding trust within 180 days. This exchange is popular because of the longer timeframe; identifying a preferred replacement property is allowed up to 45 days, and the closing of the sale up to 180 days.

Construction Exchange 

Taxpayers who want to improve the property through construction can make use of the deferred tax money with equity. This exchange is very useful, especially when there are also rental property management costs to think about. Investors put up large investment capital for the upkeep and maintenance while keeping other risks in mind.

However, the replacement property is temporarily held by the qualified intermediary for 180 days.

Requirements also include the following:

■ Identify a similar property in-kind with a similar or greater value in 45 days.

■ Within 180 days, use the equity for the property construction or as partial payment.

■ The intermediary will only release the title back to the taxpayer once the improvements are complete.

In Conclusion

The 1031 Exchange is not for every investor, for a few reasons. One, it requires a sizeable investment, since deals in the real estate business involve a lot of money.

Two, not everyone has the patience to understand how the real estate business works. It requires your patience to acquire knowledge, follow trends, learn what works and minimize risks.

The 1031 Exchange is highly beneficial, and you can expect a sizable ROI when you know how to take calculated risks. However, you can and should always count on expert financial advice from trusted professionals, who are knowledgeable in the real estate business.

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