What is a 1031 Exchange?

A 1031 exchange (IRS Code Section 1031) gives an option to the investor by reinvesting the proceeds from the sale of investment property (known as the “relinquished property”) into qualified replacement property to defer capital gains tax. The net result is that the exchanger can use 100% of the proceeds (equity) from their sale to buy another property and defer the capital gains tax.

Property involved in a 1031 tax deferred, like kind exchange must be held for productive use in a trade or business, income production (rental) or investment purposes.

1031 "Like-Kind" Exchange Explained

1031 Like Kind Exchanges originally began as 1031 Tax Swaps of properties between two parties, often farmers trading parcels of land with one another. Over the past 20 years, the regulations regarding 1031 exchanges have become clearer and now allow investors to conduct 1031 Exchanges with more guidance. Today, 1031 tax-deferred exchanges are used by both corporations and individual property owners as part of their investment strategy.

A 1031 Exchange can potentially provide real estate owners with greater leverage, increased diversification, improved cash flow, increased potential for geographic relocation and potential property consolidation. However, there is no guarantee that these objectives can be met. As with all real estate investments, there is a degree of risk.

The strict identification and timeline rules laid down by IRS must be followed during a 1031 tax-deferred exchange. It can be a powerful wealth building tool. To ensure that every requirement of Section 1031 is met, a professional tax advisor should be utilized. Failure to do so can result in associated penalties plus immediate tax liabilities.

1031 Exchange permits investors, in addition to tax deferral, to purchase a leveraged replacement property and thus increase their basis in the amount of additional debt assumed. This can shelter as much as 50% to 60% of the rental income cash flow from income taxation. The after-tax return on investment on an annualized basis can be even greater because of the possibility of additional return from appreciation of the property.

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The Advantages of 1031 Tax-Deferred Exchanges

Experienced as well as new investors continue to take advantage of the 1031 tax-deferred exchange. With the property appreciation and strong economic growth, that we have been witnessing in many areas throughout the county over the past several years, it completely makes sense. A 1031 exchange also provides the benefit of diversification, leverage, management relief, consolidation and increased cash flow and income along with giving the investor a tremendous increase in purchasing power.

LEVERAGE

A 1031 tax-deferred exchange can be used by the investors to acquire a more valuable investment property. By utilizing the money which they would have otherwise paid to the IRS in taxes, they can improve their overall buying power and increase their down payment to acquire a more expensive replacement property. Thus, through 1031 Exchange, Investors can leverage their cash and continue building wealth through real estate investment

CONSOLIDATION/DIVERSIFICATION

An investor may exchange one property for several others, acquire property anywhere within the United States and even consolidate multiple properties into one because of the flexibility of the 1031 exchange, an. For example, an investor can exchange two single room houses for a retail strip center or exchange one property in California for three properties in Arizona taking advantage of a new growth area.

MANAGEMENT RELIEF

Investors that have several rental properties are often loaded with the burden of costly maintenance and intensive management of their properties - which often leads to increased problems for them! An investor can decrease time and effort as wells as increase profits by exchanging out of high maintenance rental properties and consolidating into NNN leased investment or an apartment building.

INCREASED CASH FLOW/INCOME

A 1031 tax-deferred exchange can help the investors by increasing the cash flow and overall. For example, a vacant piece of land that generates zero cash flow or has no depreciation benefits can be exchanged for a commercial building that does have both of them.

INCREASED PURCHASING POWER

The following illustration below will help you understand the financial power of a 1031 exchange.

Assumptions:

  • Capital gain is taxed at a maximum capital gains tax rate of 20%
  • Depreciation is recaptured at 25% (for individual taxpayers)
Original Cost (Basis)$200,000
Plus Capital Improvements$40,000
Less Depreciation$70,000
Equals Adjusted Basis$170,000
Sales Price$1,000,000
Less Adjusted Basis$170,000
Less Costs of Sale$80,,000
Equals Capital Gain$750,000
Funds available for reinvestment w/o exchange (not including state capital gains due)$766,500
Funds available for reinvestment w/1031 exchangers$920,000

 

If this investor decides to purchase a new property using all cash, the investor has an additional $153,500 to reinvest by utilizing a 1031 tax deferred exchange.

It’s very clearly visible why a 1031 exchange is a valuable tool for real estate investors. So have you yet spoken with your advisor, You can schedule an appointment with one of ours 1031 Experts / Advisors now for FREE.

1031 Exchange Do’s and Don’ts

DO plan in advance

The key to success in 1031 exchange is advance planning. Proper attention must be given to the timing of the sale of the relinquished property, estimating equity and debt replacement objectives to avoid boot, and retaining an expert qualified intermediary.

DO NOT miss your deadlines

The IRS will not honor the exchange if either of the two timeline are missed – the 45-day identification period , or  the 180 day exchange period to acquire the replacement property.

DO make every effort to sell before you purchase

If you identify an ideal replacement property before your relinquished property is sold, then you may have to negotiate a reverse exchange (i.e., buying before selling). The IRS has provided guidance on this type of reverse exchange in Revenue Procedure 2000-37, but a reverse exchange is considered a more aggressive type of exchange as either the replacement property or the relinquished property must be parked with an Exchange Accommodator Titleholder for 180 days, pending the successful completion of the exchange.

DO NOT change the property title during the exchange

Changing how title to your property is being held or dissolving partnerships during the exchange may cause the exchange to be dishonored due to holding-period issues.