1031 Exchange
What is a 1031 Exchange?
Section 1031 of the Internal Revenue Code (IRC) defines "Like Kind Exchanges" or "tax deferred exchanges". These exchanges present taxpayers with an excellent opportunity to build wealth and save taxes. By doing a 1031 Exchange, the taxpayer (also known as the "Exchanger") can dispose of investment or business-use assets, acquire replacement property, and defer the tax that would typically be due upon the sale.
Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. This means that the taxes which otherwise would have been due from the sale are deferred.
A 1031 Exchange allows investors to defer federal capital gains tax, state ordinary income tax, net investment income tax, and depreciation recapture on the sale of investment property, provided that specific criteria are met.
Potential Benefits of a 1031 Exchange
Tax Deferral
A properly executed 1031 Exchange may allow investors to defer State and Federal income taxation upon the sale of appreciated real estate, thereby preserving equity and potentially maximizing total return.
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Ongoing Tax Benefits
A portion of any monthly income may be offset by depreciation.
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Increased Cash Flow
Investors seeking more current income can 1031 exchange from non-income producing or underperforming assets into one or more high-quality properties that may generate monthly income.
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Capital Appreciation
Growth in the overall value of real estate holdings is necessary to overcome the effects of inflation. A 1031 Exchange may provide investors the opportunity to allocate their capital into assets that may increase the potential for appreciation.
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Diversification
A tax-deferred 1031 Exchange can be a powerful tool to realize investment diversification, which may be achieved by: diversification in geographic region (multiple properties in multiple states); asset class (office, industrial, retail, multifamily); tenant industry and creditworthiness; capitalization structure (debt vs. equity); and/or ownership structure (fee simple vs. leasehold and severalty vs. co-ownership).
Estate Planning
Currently, it is possible to exchange like kind real estate indefinitely over a lifetime, continually deferring capital gain and transferring basis to each subsequent property until the taxpayer’s death. The subsequent heirs who inherit real estate, whether it has been part of a §1031 exchange or not, receive the “stepped-up” basis which is generally defined as the fair market value of the inherited property at the time of death.
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1031 Exchange Rules to follow
For Complete Tax Deferral, Investors Must:
01.
Use a Qualified Intermediary (QI)
02.
Reinvest 100% of the net proceeds and debt
03.
Be the same taxpayer during the exchange
04.
Identify potential replacement in 45 days
05.
Close on replacement property(s) in 180 days
Identification Rules
It is essential to understand how the new Replacement Property is "identified" in a 1031 Exchange. This is because there are strict timelines and rules set by the IRS that must be followed accurately to ensure that your exchange qualifies for tax deferral. Here are the Identification rules you must follow:
Three Property Rule
The taxpayer may identify up to three properties of any fair market value and purchase any (or all) of them, regardless of the total value. This is the most commonly used identification rule.
200% Rule
The taxpayer may identify an unlimited number of properties provided the total fair market value of all properties identified does not exceed 200% of the fair market value of the relinquished property.
95% Rule
If the taxpayer identifies properties in excess of both of the above rules, then the taxpayer must acquire 95% of the value of all properties identified.