Why Do A 1031 Exchange
Investors have three things that they can do with an investment property. They can hold the property, they can sell the property, or they can exchange it.
If you are enjoying a good return on your investment through rental income and/or you anticipate a rising market with good capital gains growth, holding is usually a great option. Of course, there could be other justifications for holding the property, such as for sentimental reasons or many other reasons.
Your next option is to sell the property. If you choose to sell the property, and your property has gone up in value since you purchased it, you will need a smart plan if you want to reinvest those funds.
At the time you sell you will owe taxes. The challenge is when you re-invest in something else, you will have less value to employ than you had before because Uncle Sam will have taken his share of the capital gains.
While you own the property, and it is rising in value, the federal government allows you to defer paying taxes on the increase in value until you sell the property. So, in a way, it’s almost like the government is giving you a loan. Any time you defer the payment of taxes on an investment by not “realizing” the gains, the value of those gains leverages the return.
As with the traditional IRA, or a tax-deferred annuity, where taxes are deferred until money is withdrawn, growth within the investment is bolstered by increasing value of the tax-deferred growth. You benefit from a return on investment that is supercharged because you have not been taxed on gains…yet.
How can you sell the property, take that big bite from taxes on gains, and still achieve the same return on investment? That may not be easy.
There is an option available that allows you to sell your property and reinvest the proceeds in another investment while deferring capital gains. This option is a 1031 exchange, named after IRC section 1031.
Using this legal tactic, you have the option of deferring all of the capital gains or some of the capital gains.
Most people who choose to use a 1031 exchange choose to redeploy the entire amount (basis plus gains) by purchasing a new property of equal or greater value. If you choose to purchase an investment property of less value, then you will be required to pay taxes on the portion not reinvested, referred to as the “boot”.
There is no limit to the number of times you can do a 1031 exchange, rolling the gains from one property to the next.
A 1031 exchange comes with numerous regulations, such as:
The replacement property must be of ”like-kind” (referring to the nature of the property, not its quality).
The good news is that “like-kind” is now interpreted very liberally. For example, you can exchange an apartment building for raw land. “Any property held for productive use or trade or business or for investment can be exchanged for any other property held for productive use in trade or business or for investment.” (Conversely, the “boot” is any property received during the exchange which is not considered to be “like-kind” such as the actual receipt of cash proceeds which are part of the capital gains).
You cannot use your primary residence, or a property held for the primary purpose of resale (such as with flipping). A 1031 is only for real property investments that are held for a period of time.
Pre-December of 2017, there were cases when personal property could qualify, such as equipment. This is no longer true.
Timing is everything
You must identify the replacement property within 45 days of closing on the sale of the original. In addition, you must close on the sale of the replacement property within 180 days of the closing of the original.
Most 1031s are delayed exchanges. This is important because the chances of you actually finding someone who wants to swap with you directly is unlikely. This typical form of 1031 exchange uses a middleman to hold the cash from the sale until you are able to buy the replacement property. The middleman is referred to as a qualified intermediary and is usually an attorney.
Since we are currently in a sellers’ market in Charleston, you may need to consider doing a reverse exchange. A reverse exchange is closing on the replacement property before closing on the sale of the property you’re getting rid of. This is most likely to happen when the seller needs to close quickly and you’re in a highly competitive sellers’ market. In order for your offer to be competitive, speed may be required. There are different ways this can be done but each will require the use of a qualified intermediary.
Primary advantages of a 1031 exchange:
Preservation of equity
Investment leverage - proceeds can be used to purchase a more expensive property augmented by a loan to boost potential return on investment
Realignment of investment objectives - you have the option of investing strategically, such as moving equity from a property in one region to a property in a region with a higher appreciation potential. Even exchanging multiple properties for one property, given the added benefit of reduction of management complexity, is available.
Getting a better investment - You may have the option of doing an “improvement exchange”. The purpose of this is to allow the buyer to make improvements on the property being purchased by using exchange equity. You can use tax-deferred dollars to make a better investment than what might be available today on the market to purchase; or, you may be able to use the equity to actually build a new property from the ground up.
Some big pitfalls
Watch the mortgages
One of the biggest ways you can get into trouble with a 1031 exchange has to do with the difference between the mortgage on the original property that you are selling and the mortgage on the property you are purchasing. Any debt reduction (for example, the original property had a mortgage of $1 million but the replacement property has a mortgage of $800,000) is treated like income and it will be taxed.
Mistakes, such as in timing, can cost you the deferment forcing you to pay taxes now on the sale.
In a delayed exchange, it is very important that you do not receive the cash directly (use a qualified intermediary) because if you receive cash yourself, the exchange will be spoiled and your tax benefit will be wiped out.
Can you avoid the taxes on the gains forever?
There are ways that you may be able to avoid ever paying taxes on the gains. For example, if you move into an investment property and live there using it as your primary residence, in some circumstances you may be able to sell the property, taking advantage of the IRS $500,000 joint exclusion, and avoid paying taxes on the previously acquired capital gains. Generally, this will require a longer period of time in the home. Rather than living in the home for two years, you’ll be required to live in the home for five years in order to take advantage of this tax benefit.
Warning: do not attempt a 1031 exchange without consulting a qualified attorney in advance
Before you do any 1031 exchange, it is very important to consult both your attorney and your tax advisor. The process can have many elements, options, and traps. In order to not get caught owing taxes or penalties, use qualified professionals to help.
If it is right for you, just do it
From the standpoint of the consumer, doing a 1031 exchange is simple with the guidance of qualified professionals. Your attorney, tax advisor, and Realtor will assist you along the way to make the process painless.
Of course, nothing in this blog is intended as tax advice or investment advice.
Have any questions? Give me a call.
Author: Chris DeLoach
April 18th 2018
About Chris: Serving Charleston buyers and sellers since 2001
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