1031 Exchanges
A 1031 Exchange allows an owner of an investment property to sell a piece of real estate and to acquire another piece of real estate within a set timeframe, while deferring any Capital Gains Tax liability on the sale of their property. The deferred Tax will ultimately have to be paid when the new piece of real estate gets sold, or deferred even later if another 1031 Exchange is utilized.
Advantage to deferring Tax?
A 1031 Exchange is named after Section 1031 of the United States Internal Revenue Code. Why would an investor utilize this Tax Code if ultimately they have to pay the piper anyway? The big advantage to deferring your Tax liability is having more capital available today to buy more real estate. As the majority of real estate is bought with leveraged debt, the larger the acquisition you can make today using leverage, will allow you to amplify your future returns on today's invested capital (so long as there is price appreciation in the investment of course!).
Prior to the Tax Cuts and Jobs Act 2017, multiple asset classes were eligible for a Tax Deferment under a 1031 Exchange, such as aircraft. However, the Jobs Acts now specifically only permits real estate as being eligible for a 1031 Exchange. This continues to highlight the preferential Tax treatment real estate receives.
1031 Exchange rules in simple terms:
The property being exchanged must be held for productive use in a trade or business, or for investment.
The property exchanged must be of a "like kind". This does not mean the property type has to be the exact same, for example exchanging a 10-unit apartment building for another 10-unit apartment building. It simply means the real estate has to be of the same nature or character, such as one investment property for another. An apartment building could be exchanged for a retail building.
Both properties must be within the United States.
People who hold properties as inventory, such as a home builder or office building developer, or who purchase properties for immediate resale, are considered "dealers" and are prohibited from using a 1031 Exchange.
The original 1031 code was intended for a simultaneous transfer/exchange of ownership. This proved very difficult to adhere to, given the multiple buyers & sellers involved, and consequently the coordination of timing. After the Tax Code was challenged in court, the rules were changed to allow for a delayed 1031 Exchange.
A delayed 1031 Exchange still has a strict window in which to perform. The replacement property must be identified within 45 days of the sold property closing. The replacement property must be acquired within 180 days of the sold property closing.
With delayed 1031 Exchanges, you must use a Qualified Intermediary who will hold the proceeds of the sold property and release them for the acquisition of the replacement property.
To receive the full benefit of the Tax deferral, the replacement property should be of equal or greater value of the relinquished property. If the replacement property is of lesser value, there will be a partial Tax liability.
The debt balance on the replacement property should also be equal or higher than the relinquished property, otherwise this can also create a partial Tax liability.
You may relinquish one property and acquire multiple replacement properties in the same 1031 Exchange, it does not have to be one property exchanged for one property.
You may do a Reverse 1031 Exchange, where you identify and acquire a replacement property first, and have 180 days to sell the property you are relinquishing.
Utilizing a 1031 Exchange offers huge investment opportunity by giving you more capital to reinvest from the sale of your relinquished property. It also allows you to trade in & out of properties within certain geographies, and/or within certain asset classes, as market cycles play out, all without triggering a Tax liability payment.
To successfully pull off this strategy requires careful planning to keep within the strict deadlines. It is also important to work with a well-established and reputable Qualified Intermediary who will keep you on the right side of the IRS Code. Equally as important is working with a seasoned real estate broker who can execute quickly on the buy & sell side of the transaction, and a loan broker that will have the new acquisition debt financing ready to close.
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Call or email me if you would like assistance making your next real estate transaction as profitable as possible.
michael@mulcahycapital.com
https://www.mulcahycapital.com
+1-617-861-2042
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