When it comes to real estate investing, some investors simply ignore or are not familiar with the 1031 exchange tax. Some investors are not acquainted with its essentials (such as time frame, limitations, or various structures). But, when you consider real estate investing as a part of your investment portfolio, you should be advised on tax-deferred exchanges. The best way to avoid unnecessary payments is to thoroughly look at the advantages and the disadvantages of tax exchange transactions.
The business world is constantly changing, and it is almost impossible to keep tabs on all the dynamics on your own. For that reason, feedback from other investment specialists is always welcome.
Westwood Net Lease Advisors are here to guide through some common misconceptions and to give advice about what works best and which strategies are the best to employ.
The following article will give you insight into the concept of a 1031 exchange tax and provide some of the top reasons why incorporating a 1031 exchange into your investment may be a good option.
1031 Exchange Tax – What Lies Behind?
The 1031 Exchange tax is under Section 1031 in the Internal Revenue Tax Code. This tax serves as a business strategy to the investor in such a way that he or she can sell a property and reinvest the capital gains into another property. Thus, he can defer all the capital gains taxes.
To clarify, there is neither gain nor loss on the relinquished property but this is only if it is sold and replaced with a ‘like-kind’ property meant for business or investment purposes.
The taxpayer would be able to get rid of the relinquished property and choose a replacement property of ‘like-kind’.
Certain properties do not qualify for 1031 Exchange transaction. Such properties are personal residences, inventory properties, partnership interests etc.
In contrast, upgraded real estate properties may be replaced with non-upgraded or other properties. Another option is that a property is replaced with two, three or more other properties or otherwise.
1031 Exchange Tax – Why Choose It?
There are several benefits to both the client and the investor when utilizing a 1031 exchange tax.
- Clients can enjoy deferred payments of capital gains taxes. The funds that are used in a 1031 exchange transaction can now be reinvested into another property. The highest capital gain rate is 20% of the gain. When the property is being sold, the depreciation is recaptured and corresponds to 25% tax.
Let’s take an example:
If a client owns a property for a long period of time and bought it for $200,000, the mortgage balance could be at $100,000. With no capital improvements, the depreciation deduction on the property could be $100,000. Now the property will be sold at twice the price (for this example, $400,000). If the client had to pay taxes, then the amount would have been 25% of $100,000, that is $25,000 depreciation recapture. 20% of $200,000 would have to be paid in federal income taxes, $40,000 to be exact. State income taxes could cost 5% of $200,000 ($10,000). The total amount of taxes would be $75,000. The net proceeds for reinvesting would then be $225.000 after the mortgage payout. But if the client decides to use 1031 exchange tax in the sale of the property, the taxes can be deferred to a later date and the reinvestment amount would be $300.000.
- Real estate agents can enjoy numerous referrals if the clients are satisfied. Agents can also double the commissions if the client buys a replacement property and secures the commission on the purchased property.
Many people ignore the 1031 exchange tax as they think that 1031 exchanges are only for more valuable properties. However, most of the properties which cost less than $300,000 can be included in an exchange transaction.
Along with these benefits, there are a few other reasons why you should not ignore a 1031 exchange.
- Appreciation- the value of the property may undergo maximum appreciation
- Depreciation- the property can be fully depreciated
- Cash flow- the property can have a low cash flow
- Diversification- the property may have potential for a good sale and thus be diverse investment
- Consolidation-the investor can be released from the management of multiple properties
Utilizing 1031 Exchange Tax means that the investor will have numerous tax and investment goals. This section allows the investor to defer several types of taxes including federal capital gains tax, depreciation recapture tax as well as income tax and state tax. The investor will be able to buy a property with an increased cash flow and give an interest deduction. If the amount of the replacement property is higher than the amount of the relinquished property, there will be depreciation deduction.
Another option is that a single property may be exchanged for multiple like-kind properties, and thus the investment portfolio will be diverse (a residential property may be exchanged for a commercial).
Later, the investor can exchange a property for a larger investment property. The new property will be easier to manage. Investors can also exchange a residential or commercial property for another property that is less time-consuming.
1031 Exchange Tax – What Are The Rules?
- The taxpayer is the same- The taxpayer needs to remain unchanged, (the same person who sells and buys the property). The tax return must also be the same for both the replaced and relinquished property.
- Property Identification Period- After the closure, property identification must be done within 45 days. The taxpayer has to comply with a final list of sale and purchase properties within that time period.
- Replacement- The taxpayer must purchase the replacement property within 180 days after the closure of the first property.
- Trading up- The replacement property may have equal or higher value than the relinquished property. If the net value of the sold property is greater than that of the purchased property, then the taxpayer must pay the additional tax to cover the difference.
- Hold time- The Internal Revenue Code does not offer hold time for the 1031 Section. However, the service needs to check whether the property is being purchased shortly after the transaction. The exchange is affected by various factors, including time which ‘supports the intent to hold for investment’.
- Related party- It refers to anyone who is involved in the exchange transaction and is somehow related to the taxpayer.
A 1031 Exchange offers various advantages for the investor and the client. However, we would recommend that you consult with Westwood Net Lease Advisors before considering 1031 for your investment portfolio.
Leverage, diversification, consolidation, cash flow, management, depreciation are just a few things you should be advised on. Investors may purchase properties in multiple states, or sell a smaller property for larger property (thus minimize the management responsibility). Investors may also sell a property with little or no income and buy another with considerable cash flow. They can also switch high-maintenance properties with those that require less management.
Another option is to swap a non-depreciable property with one that has depreciation potential.
To be able to do 1031 exchange transaction, the property intended for sale must match with the property which is about to be purchased. In other words, it must be ‘like-kind’. Another reminder: you cannot sell a residential property and buy another residence. Only business and investment properties can qualify for the 1031 exchange. Also, you need to be careful when swapping these properties if the replacement property does not have equal or higher net value. You won’t be able to do 100% tax deferral.
If you have any questions, please do not hesitate to call.